Quantitative tightening likely this fall: What it might mean for markets
The U.S. Federal Reserve (the Fed) has made it very clear that it intends to start winding down the size of its $4.5 trillion balance sheet1 soon. We are looking for Fed Chair Janet Yellen to announce that decision at the Federal Open Market Committee (FOMC)’s next meeting in September, and most economists agree. This is important, as it marks the beginning of the end of the extraordinary stimulus that the Fed injected during the Great Financial Crisis. But not all Fed tightenings are created equal for markets. In this post, we’ll explore:
- The mechanics of balance sheet normalization;
- Why “quantitative tightening” is different than a conventional rate hike for markets; and
- Our broader macro outlook for the next 18 months.
Balance sheet normalization—a euphemism for quantitative tightening (QT)
If you’re not an economist nerd (like me), thinking about the implications of balance sheet policy for financial markets might seem like an unpleasant task. But a quick retrospective on the financial crisis goes a long way to helping understand how we got to this point and the path forward.
Back in December 2008, the Fed cut its overnight interest rate to zero. But the crisis was so severe that even “free” short-term money wasn’t enough to reinvigorate growth. The unemployment rate continued rising from 6% (when rates were cut to zero) to an eventual peak of around 10%.2 The Fed needed to do even more to jumpstart the U.S. economy. So, they embarked on a series of large-scale asset purchases—the Fed bought longer-term Treasuries and mortgage-backed securities with the expressed goal of lowering long-term interest rates. These asset purchases that were later dubbed “quantitative easing” were effectively just a second, more experimental policy lever that was necessitated by the severity of the crisis.
It’s certainly been a very long road to recovery, but by many measures the U.S. economy is back to normal. And so the Fed is gradually withdrawing its policy support. Janet Yellen has already raised rates four times this cycle. The reason for pulling this lever first was to build up some conventional monetary policy ammo in case the Fed was blindsided by an unexpected recession. With the short-term interest rate now back above 1%, the Fed has scope to cut rates if needed.
The balance sheet is next. At the June 2017 FOMC meeting, the Fed laid out a detailed plan for exactly how they intend to wind down the size of their balance sheet. At the time, we wrote about three key features of this blueprint for investors:
- First, that the Fed was taking a passive approach—they don’t plan to actively sell any of their bonds. Instead, they will simply stop reinvesting the securities upon maturity.
- Second, the Fed plan is very predictable. Investors know the exact dollar amounts of bonds that will be allowed to roll off for the next several years. This removes uncertainty from the market and should cushion against a sharp rise in volatility like the “taper tantrum” of 2013.
- Finally, the Fed is doing this at a measured pace. The Fed will impose caps on how quickly the balance sheet gets wound down. At its peak, the Fed will allow $50 billion per month of runoff. That is significantly slower than the peak of the Fed’s quantitative easing program when they were buying $80 billion per month. Indeed, San Francisco Fed President, John Williams, has described the Fed’s balance sheet approach as “boring” and Janet Yellen has described it as being like “watching paint dry”.
What does it mean for markets?
Markets can handle boring. Directionally, quantitative tightening (QT) should raise long-term interest rates in the same way that quantitative easing (QE) lowered them.
The basic idea is that the Fed is slowly stepping away from the fixed-income market, and yields need to rise to induce replacement demand from private sector investors. But our analysis suggests that the magnitude of the increase in yields should be modest. All else equal, the Fed’s plan is likely to lift the 10-year Treasury yield by just 10 or 20 basis points over the next twelve months—similar to an estimate from a recent Fed note. Stronger global growth and a gradual, global shift away from peak monetary policy accommodation should also exert upward pressure on U.S. rates. We expect the 10-year Treasury yield to edge up to a range of 2.5-2.75% over the next 12 months.
Currency markets are more exposed to changes in expectations about short-term interest rates and are therefore relatively insulated from this process. My colleagues Van Luu and Keith Brakebill forecasted that the U.S. dollar would peak in late 2016. And, indeed, the trade-weighted dollar is already down 8.5% this year.3 At current levels we have a neutral tactical view on the dollar. Instead, our highest conviction call is for euro strength relative to the Australian dollar and Japanese yen.
Higher long-term interest rates are a headwind for the rich valuation multiples of the U.S. equity market, but they are unlikely to be a show-stopper. We continue to see better opportunities in non-U.S. markets. Valuations are relatively attractive in regional equity markets like emerging markets, the eurozone, and Japan. And stronger economic and earnings growth in non-U.S. markets has been an important engine for the global cycle thus far this year. This global strength has certainly benefitted the U.S. as well—almost 45% of S&P 500 Index revenues are sourced from abroad4—but we think investors will benefit the most from positions that are more exposed to a stronger international cycle.
One final point—there is a feeling of concern among many of the clients I talk to that this is an unprecedented step away from an unprecedently accommodative monetary policy. The “we’ve never seen this before” feeling has created concern that we could be on the brink of a left-tail event in markets. While those risks are apparent in some areas—the U.S. expansion is eight years old and valuations are rich—there’s a similar experience we can look to from the 1950s for guidance.
During World War II, the Fed helped to finance the war effort by purchasing Treasuries (they bought shorter-term bonds at the time) and adopting an implicit target of 2.5% on the 10-year bond. The Fed’s balance sheet ballooned to around 20% of GDP by the end of the war. In 1951 the Fed finally convinced the administration to abandon the 10-year yield target, and the Fed’s balance sheet gradually shrunk to around 5% of GDP over the following three decades.5
What happened to markets? Not much—the 10-year Treasury yield edged up from 2.5% in March 1951 to 2.6% in March 1952.6 Yields continued to nudge higher until the economy dipped into recession in 1953.
The lowflation puzzle and the path forward for U.S. monetary policy
We believe the bigger economic issue for markets is the low inflation backdrop. Core consumer price inflation has significantly disappointed consensus expectations over the last five months from March to July. To put the recent soft patch in historical perspective, the recent five-month stretch of core inflation weakness is the second worst stretch of data in the last 50+ years.7
In our Global Market Outlook from a few months ago, we argued that “the downside to inflation could prove more persistent.” But we were also somewhat surprised by the depth of the recent weakness in price inflation. Coupled with our mediocre economic growth outlook, we think the Fed will hold its policy rate steady for the remainder of the year. Fixed-income markets have converged to this view, with fed fund futures currently pricing only a 33% probability of a December rate hike.8 An increasingly dovish tone from Fed Governor Lael Brainard (an influential economic thinker on the Committee) and Dallas Fed President Robert Kaplan (a centrist who tends to closely track Janet Yellen’s thinking) also supports our view.
1 Source: https://fred.stlouisfed.org/series/WALCL
2 Source: https://data.bls.gov/timeseries/LNS14000000
3 Source: DXY Dollar Currency Index, Thomson Reuters Datastream as of August 14th 2017
4 Source: S&P Dow Jones Indices, July 2017. https://www.spglobal.com/spdji/en/documents/index-news-and-announcements/20170720-sp-500-global-sales-2016.pdf
5 Source: https://www.nber.org/system/files/chapters/c11485/c11485.pdf
7 Source: BLS, Russell Investments calculations as of July 2017.
8 Source: Bloomberg. Data as of August 11th 2017.