THE LONG UNWINDING ROAD

(TECHNICAL)

The US Federal Reserve (Fed) has unveiled plans to start shrinking its balance sheet, which has more than quadrupled in size since the global financial crisis (GFC). The multi-year massive expansion of the Fed’s balance sheet has had a recognized powerful effect on asset markets—lowering yields and flattening the yield curve. Yet investors now seem to expect that the reverse process will have little impact, if any.

We disagree. We believe three factors have the potential to push bond yields higher; any single one could be sufficient to push yields well beyond current market expectations, and we see very little chance that none of them will materialize.

First, as the Fed reduces its purchases and the US Treasury increases supply to finance the ongoing fiscal deficit, new buyers must step in to keep the market for US Treasuries (USTs) in equilibrium. Our analysis shows that the burden will fall disproportionately on domestic, price-sensitive buyers like banks, mutual funds, pension funds and corporations. For these buyers to increase their demand, UST prices must fall and yields rise.

Second, as the Fed unwinds its balance sheet in a gradual manner, banks’ excess reserves will remain extremely high for the next few years. A well-entrenched and strengthening economic recovery will give banks a growing incentive to increase credit supply—all the more so as financial regulations will likely be eased over the coming year. With stronger global growth and bolstered confidence, credit demand will also likely rise. This underscores the risk of a faster-than-expected acceleration in credit, which could further stimulate growth and raise inflation.

Third, wage and price pressures are unlikely to remain muted as the US economy, having reabsorbed all economic slack, keeps growing above potential—and the global economy with it. We find arguments that the wage and price Phillips curves1have permanently flattened unconvincing. Moreover, both wage and price trends have a strong global component, and inflationary trends in the global economy are now likely to get stronger.

To assume that none of these three factors will come into play would be, we believe, foolhardy. As the Fed unwinds its balance sheet, we should ask not whether yields will rise, but how much faster and higher than market expectations.

In our full-length topic paper, we discuss:

  • Section 1 – the global economic backdrop
  • Section 2 – the monetary policy normalization challenge
  • Section 3 – the likely path of Fed balance sheet unwinding and it assesses the potential impact on asset markets
  • Section 4 – the risk that vast excess reserves will fuel an acceleration in credit
  • Section 5 – the potential macroeconomic pressures for higher inflation

For more insights, read the latest edition of Global Macro Shifts, The Fed’s Long Unwinding Road, with commentary from Dr. Hasenstab and senior members of Templeton Global Macro.

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