Over the past few months, financial markets have cruised smoothly through a sea of uncertainties: geopolitical tensions on the Korean Peninsula, in the Middle East, and in Russia; sharply lower commodities prices; the Federal Reserve’s tightening of monetary policy and its announcement that it will begin to reverse its quantitative easing program; and gridlock in the U.S. administration.
Against this backdrop, the strong recent market performance and decline in volatility is remarkable. What is behind the calmness of financial markets? In our opinion, it has been a combination of disappointing growth in the U.S., acceleration of growth in the rest of the world, and modest headline inflation. Together, these factors have taken the pressure off the U.S. yield curve while preserving global growth. Will they continue to provide a risk-friendly backdrop? Probably not: We believe the tides are going to change and that navigating the markets is going to become much trickier.
At its June meeting, the Fed raised the U.S. interest rate by 0.25% and revealed more details about how it will unwind its USD $4.5 trillion balance sheet. During the subsequent press conference, Fed Chair Janet Yellen indicated that the balance sheet reduction will be initiated “relatively soon,” which we take to mean either at the July meeting or, more likely, the September meeting. Yellen also said the process of balance sheet retrenchment would be so unspectacular it would be “like watching paint dry.”
Initially at least, she may be right: The early pace of retrenchment is likely to be gradual, and, given the scale of excess liquidity in the system, we believe that the Fed will be able to implement it without causing too much harm. After that, however, we are set to transition from a world in which cash balances grow by USD $500 billion per quarter courtesy of monetary easing in Europe and Japan to one in which cash balances are unchanged—and that’s when things will become more challenging.
In a world in which cash balances grow rapidly, households, companies, and asset managers are continually faced with the challenge of having to reinvest cash, providing strong support for asset markets. The world to which we are transitioning has no such endogenous growth of cash balances and there is, therefore, nothing to continually force households, companies, and asset managers to deploy cash. Over time, the reversal of quantitative easing will cause volatility to resurface. A second challenge for the Fed is that it looks set to initiate the balance sheet adjustment at a time where growth outside the U.S. is set to slow. Tightening monetary policy in an environment of slower growth provides fertile ground for financial market hiccups.
The meetings of the other G3 central banks were low on information content compared with the Fed’s. Both the Bank of Japan (BoJ) and the European Central Bank upgraded the outlook for growth, with the latter changing its statement to indicate that policy rates are unlikely to be cut any further. At the BoJ meeting, Governor Haruhiko Kuroda maintained the bank’s dovish line and dismissed speculation about a possible exit from quantitative easing as premature. The fact that the BoJ has already reduced asset purchases—meaning that tapering has de facto already started—was swept under the carpet.
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