Tuesday 03 July 2018 by Warren Hogan Opinion

US monetary policy normalisation is about to bite

The first stage of US monetary policy normalisation was relatively painless. The next phase will be much more challenging for markets, bond yields will rise and attract capital from other markets, putting pressure on asset values

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The US economy continues to grow strongly

The US economy retains considerable momentum in mid 2018 with economic growth pushing 3% and the rate of unemployment falling to new cycle lows. Even wages and inflation are drifting up prior to a major fiscal stimulus due to hit the economy over the next 18 months.

Of all the controversial activities inside US President Trump’s administration, one of the most irresponsible, yet least talked about, is the injection of almost $2trn of fiscal stimulus into an economy near full capacity. This is more than just pro cyclical fiscal policy – it is a deliberate and calculated attempt to inflate the domestic economy.

The last thing the US economy needs right now is $1.5trn of tax cuts and a further $300bn of government spending. This will add between 0.5% and 1% to real economic growth this year and next, and ensure that the economy is operating beyond its capacity. Most importantly it risks making the Federal Reserve’s task of maintaining price and financial stability that much harder. Indeed, Trump may end up with a weaker economy than otherwise because of his aggressive fiscal stance.

The Federal Open Market Committee (FOMC) has made it quite clear they are happy for inflation to rise above 2% for an extended period. However, it is cognisant of inflation. Described as the snapback risk outlined by the Bank of International Settlements (BIS) in its annual report a few weeks ago. It’s fine for inflation to average 2.5% for a few years. It becomes a problem for policymakers and the economy if inflation accelerates beyond 3%.

If stimulus pushes the economy persistently through its capacity limits, wages and inflation may accelerate. Even without a tightening response from the Fed, higher inflation would push up long term interest rates and hurt economic activity.

The Fed’s game plan - gradual normalisation

The Fed is doing everything it can to maintain a long steady economic expansion. The current expansion is already the third longest on records dating back to the US Civil War.

The FOMC is in the process of removing the extraordinary stimulus that was put in place in the wake of the financial crisis. This involves the normalisation of both conventional (interest rate) policy and unconventional (balance sheet) policy. The FOMC is raising the short term interest rate while at the same time reducing the amount of securities it holds.

To date this has meant a 25bps increase in the federal funds rate every three months. Considerable progress has been made with the rate rising from near zero to just below 2%. The Fed is expecting to continue to raise the funds rate until they hit 3%; the FOMC’s view of the ‘long term neutral’ rate. Interestingly, the FOMC expects to see policy move into a restrictive setting in 2020, when the median ‘dot plot’ projection is 3.5%.

The second arm of Fed policy is the normalisation of the Fed’s balance sheet – the reversal of Quantitative Easing (QE) now referred to as Quantitative Tightening (QT). While QE finished in 2014, the Fed maintained the size of its balance sheet for three years. Only with the announcement of QT last year has the FOMC allowed the Fed to reduce the quantity of securities it holds. While the pace of QT has been building up since it was announced last September, the Fed’s balance sheet is still more than $3trn larger than it was pre crisis. There is a long way to go.

The first phase of policy normalisation was easy, for everyone

The Fed has a plan to return US monetary policy settings - both conventional and unconventional, to normal. This will ensure the future effectiveness of US monetary policy and will provide a policy buffer should the economy experience an unexpected shock.

So far the FOMC has been able to get US monetary policy from super easy to just plain old accommodative in the past two years without too many hiccups. The economy remains on a strong trajectory and despite a modest pick up in financial market volatility, overall asset values have held up well.

The orderly adjustment in bond markets has been key to the ability of the FOMC to get the Funds rate well off the zero floor without too much disruption. Not only has the government bond market avoided any major sell offs, but credit markets have been well behaved. This has meant that tighter money market conditions have not set off a chain of events that resulted in a substantial rise in long term funding costs.

The FOMC has been very careful when executing QT, engineering a gradual approach to balance sheet reduction. In the first quarter of QT 4Q17, the FOMC instructed the New York Fed to allow $10bn of Treasury and agency backed securities to run off each month. This increased to $20bn a month in 1Q18, $30bn in 2Q18 and will take another step up to $40bn in the current quarter 3Q18. The FOMC will reach the terminal paydown rate of $50bn a month by the final quarter of this calendar year which it will then maintain until the balance sheet is at a desired ‘normal’ level.

Over the 12 months to June 2018, outstanding securities on the Fed’s balance sheet have declined by $142bn or a little over 3% from $4.25trn to $4.11bn, hardly a seismic shift. This is borne out by the stability in broader interest rate markets where yield levels and credit spreads have been contained through this first phase of policy normalisation.

The next phase will be much more problematic; particularly for riskier asset classes

The most disruptive element of the next phase of policy normalisation is QT. The magnitude of QT to date is very small compared to what’s coming. Figure 1 shows the quarterly change in the Fed’s security holdings (weekly data) since the failure of Lehman Brothers in September 2008. The big securities purchases associated with QE I through QE III are very clear on the chart. The rundown of securities since the commencement of QT last year has been minor in comparison.

Quarterly change in Federal Reserve security holdings


Source: Federal Reserve, EQ Economics
Figure 1

In the coming financial year, the value of securities the Fed holds is expected to decline by more than four times the $140bn that occurred in the past year at $570bn. The trickle that has been QT to date is about to turn into a wave and the implications for market volatility and asset values will be significant.

As it is uncharted territory, the market is struggling to fully understand the impact of QT. The channel through which it operates is market liquidity. As the Fed allows securities to mature without reinvesting the proceeds the supply and demand balance in the bond market shifts. Lower prices must be the result.

This is the double whammy impact of Trump’s fiscal stimulus. By increasing the US government deficit, the supply of Treasuries is not going to fall, rather it will probably increase. This increasing supply of Treasuries will occur just as the biggest buyer in the market, the Fed, retreats. There can be little doubt that bond yields will rise in response.

The impact on financial markets will not be limited to the Treasury and Agency debt markets. Rising yields on Treasury and Agency debt will draw money in from other asset classes. This implies a constant tug of war between bond markets and riskier asset classes (such as equities and property) as yields rise.

I don’t expect these markets to ‘crash’ but money will move into bond markets as yields rise, which will put downward pressure on the price of securities in other markets. In this environment it is hard to envisage a strong performance from asset markets despite the otherwise healthy underlying economy. Overvalued equity markets should move towards a level in line with historical fair values.

Risky asset classes to struggle; market volatility to rise

Trump’s fiscal stimulus combined with QT means that the market is going to have to find about $600bn a year to fund the government. This should ensure a volatile year for financial markets in 2018/19.

The extent to which this process creates major problems for the markets will be shaped by other factors. The strength of economic activity, political uncertainty and trade tensions are all important factors. However the most important factor will be the impact of less accommodative conventional monetary policy, that is, a rising Fed funds rate.

The uncertainties associated with QT will keep the FOMC cautious in its approach to interest rate normalisation. The main risk for the FOMC will be an unexpected increase in price pressures. The worst case scenario is one where the FOMC is forced to up the pace of conventional tightening while QT is putting upward pressure on term yields and creating volatility in markets. And again, this is where Trump’s fiscal stimulus is unhelpful. This fiscal stimulus has increased the chances that the economy will start generating inflation given that it comes when the economy is already operating at capacity.

Get ready for a bumpy 2018/19 in markets.


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