The dials of geopolitical and monetary risk are spinning in different directions across the globe. Of note in the U.S., markets are wondering whether glimmers of political bipartisanship bode well for reform legislation, and the Federal Reserve (Fed) is gearing up for what may be one of its most important meetings ever.
Last week: Bipartisanship, the BOE and Brexit
Last week saw a dialing down of geopolitical risk in one key region: the United States. Recall that the previous week there was a surprise announcement that President Donald Trump had made a deal with Democrats to raise the debt ceiling and temporarily fund the government and also to fund the response to Hurricane Harvey. Initially, the deal did not receive a positive reaction. However, it seems that investors may have rethought the president’s decision to reach across the aisle to his rival party. That’s because the president’s recent deal-making with Democrats increases the possibility that tax reform legislation may get passed this year — and it increases the potential for other, more bipartisan and pro-growth agenda items to come to fruition, such as infrastructure. I would argue that this was part of the reason that U.S. stocks have continued to move higher, with the S&P 500 Index passing 2,500 on Friday — for the first time ever.
Last week also saw the dialing up of monetary policy risk in the United Kingdom. The Bank of England (BOE) is in an unenviable position as unemployment is extremely low and inflation is rising to problematic levels, but the U.K. economy is in uncharted territory as it prepares for Brexit. It is unclear how the economy will fare in this environment, and this uncertainty increases the risks of starting the normalization of monetary policy at this juncture. The BOE voted to keep rates static, but minutes from its meeting suggest that it expects to begin raising rates soon after nearly a decade at current levels. Such a rate hike might be very risky as the country attempts to navigate through Brexit negotiations — with a tight deadline in the offing.
This week: Will the Fed start normalizing its balance sheet?
As we look ahead to the coming week, it’s all about geopolitical risk and monetary policy risk once again:
- The United Nations will be convening this week, and there’s likely to be more developments with regard to North Korea, which is bristling under increased sanctions. While we wait and hope for some kind of détente, we will want to pay close attention to business sentiment in countries such as Japan and South Korea. For example, business sentiment in Japan moved lower for the first time in about four months, which may be a result of the tensions with North Korea. We will want to make sure that this doesn’t dissuade corporate spending and derail economic growth.
- This week also brings U.K. Prime Minister Theresa May’s critical Brexit speech. This will be an opportunity to provide details — at least that is what many are hoping for — and set a tone for negotiations going forward. This will be followed in short order by German national elections.
But the biggest news of the week will likely come from the Federal Open Market Committee (FOMC) meeting this Wednesday.
The Fed will be meeting for what may be one of its most important meetings ever. The Fed is not expected to raise interest rates — but it is likely to announce the start of balance sheet normalization. This would be a historic event: Within the last decade, the Fed drove the size of its balance sheet from approximately $800 billion to well over $4 trillion with three rounds of large-scale asset purchases. Now the Fed appears poised to undo what it did — albeit very slowly and carefully.
As I have said before, when assessing the possible impact of monetary policy tools, I would argue that balance sheet normalization has far greater potential to affect markets than rate hikes. After all, the Fed is anything but a novice when it comes to orchestrating a rate hike cycle — but that is not the case for large-scale balance sheet normalization. We can’t forget the Fed has never had to unwind a massive balance sheet. And so, like the U.K. in the throes of Brexit negotiations, the Fed is in uncharted territory.
Back in June, the Fed released its plan for balance sheet normalization. And, of course, the plan crafted under Chair Janet Yellen is as careful and cautious as possible. The Fed plans to start tapering reinvestment ever so slightly:
- Treasuries, which represent roughly 55% of the Fed’s balance sheet, will initially see reinvestments cut by $6 billion per month. That cap will increase by an additional $6 billion at three-month intervals until reinvestments have been cut by a maximum of $30 billion per month.
- Tapering reinvestment will be even more modest for mortgage-backed securities, which represent about 40% of the Fed’s current balance sheet. Reinvestments will be initially cut by $4 billion a month. That cap will increase by $4 billion in three-month intervals until reinvestments have been cut by a maximum of $20 billion per month.
Don’t forget the Fed thoughtfully included an “escape hatch” with this normalization plan. In the Addendum to the Policy Normalization Principles and Plans released by the FOMC last week, the Fed noted: “… the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.” In other words, the Fed wants to retain as much flexibility as possible and reserve the right to temporarily halt balance sheet normalization if necessary. Resuming reinvestment is not something that could be triggered lightly — it would require a significant deterioration in the economic outlook. However, it means the Fed is not on an entirely preset course and is, to a certain extent, “data dependent.”
In short, the Fed’s plan for balance sheet normalization seems poised to ensure the least possible disruption to markets. The Fed’s goal of having balance sheet normalization operate in the background, with the focus on the fed funds rate as the primary policy tool, seems likely to come to fruition. That is certainly my base case scenario. However, we have to be prepared for the potential that “de-QE” is as impactful as QE, or quantitative easing, was on capital markets. We also have to worry about what all those open seats on the FOMC might mean for this balance sheet normalization plan. The assumption is that once a plan is announced and set in motion, the FOMC will carry through on it. However, we cannot take that for granted. There is a distinct risk that new members might steer the FOMC in a more hawkish direction.
Takeaways for investors
We will want to follow the normalization process closely, given how powerful a tool the Fed’s balance sheet is. Within fixed income, I believe investors may want to consider investments that can provide diversification — after all, we don’t have history as a guide to give us a sense of how different fixed-income instruments might react to balance sheet normalization — as well as adequate income potential given that relatively low rates are likely to persist despite the start of normalization. This may mean including sub-asset classes such as municipal bonds and emerging-market bonds. In addition, given the potential for geopolitical uncertainty to cause market volatility, investors looking for further diversification may consider increasing exposure to alternative asset classes, such as market-neutral, real estate and commodity strategies.