- Interest rate normalisation (the process of lifting interest rates again) has begun in the US, with another 2 rate hikes expected from the Federal Reserve in 2017.
- The US Federal Reserve’s other monetary policy tool is its balance sheet, which will also need to be “wound down” or normalised after many years of quantitative easing which lifted the value of balance sheet assets.
- Markets focus is around how many rate hikes the Fed will deliver in 2017. But, the Fed can use both of its policy levers (interest rates and the balance sheet) to deliver a tightening in monetary policy. This means that interest rates will rise as the balance sheet shrinks.
- The Fed is firstly going to communicate its medium-term strategy for balance sheet normalisation (perhaps mid-year), once we get another fed funds rate hike. Normalising the balance sheet is likely to begin with the Fed tapering its reinvestment of maturing assets that is likely to get underway towards the end of 2017 or beginning of 2018. Either way, balance sheet normalisation will be conditional on growth & inflation outcomes reaching the Fed’s targets.
- Normalising the balance sheet should take ~7 years, so the impact on markets and the economy will be slow & gradual. Nevertheless, we see US bond yields gradually heading higher this year along with a stronger US dollar.
Central banks control monetary policy primarily through changes to interest rates, but adjustments to central bank balance sheets have also been an important component of influencing the economy since the GFC. Improving economic conditions mean that central banks will need to start to “normalise” the level of interest rates, as well as the size of their balance sheets. After the Federal Reserve (Fed) raises the Fed Funds rate again (probably in June), markets should start considering how US balance sheet normalisation will progress over the next few years and what the impact will be on the economy and markets.
Central Bank Balance Sheets
The size of central bank assets and balance sheets have ballooned in recent years (see chart below) because quantitative easing (central bank purchasing of government bonds and other assets) became a key component of monetary policy during and after the financial crisis.
The Bank of Japan (BoJ) and European Central Bank (ECB) are still continuing with asset purchases, so central bank holdings of assets and the size of balance sheets will keep rising in these countries.
Source: Bloomberg, AMP Capital
In the US, while the Fed is no longer undertaking large-scale asset purchases the central bank is still reinvesting debt assets as they mature, which is keeping the total value of assets (and its balance sheet) unchanged. The Fed reinvests assets to ensure that the monetary conditions in the economy do not tighten too quickly, especially while interest rates are being lifted.
Interest rates are still the main tool of global central bank monetary policy. However, once central banks start lifting interest rates from record lows, balance sheets will also need to be wound down at some point, to get broad monetary conditions back to “normal” to avoid overheating the economy. Balance sheet normalisation is the second arm of monetary policy and will become a more important factor for investors to consider in 2017 and 2018 as the Fed firstly starts to openly communicate its strategy for balance sheet wind-down and then proceeds with being the first global central bank to start normalising its balance sheet after years of quantitative easing.
US interest rates & the Fed’s balance sheet
We expect that there will be more talk about Fed balance sheet normalisation from mid-year, after the Fed delivers another 0.25% rate hike (likely to be in June). Fed members have indicated that they expect the balance sheet to be unchanged until normalisation of the Fed Funds rate is “well under way”. The key for market participants now is to decide what this level of interest rates will be, where the Fed starts to wind down the value of its assets.
The US economy is fundamentally in a much stronger shape. But, there is still more room for underlying inflation and wages to rise to be consistent with the Fed’s target (see chart below). Prior periods of rate hikes occurred when wages growth was growing much faster compared to the current environment. While survey data of wage growth plans are looking much stronger, the flow-through to actual wage outcomes is yet to occur. So, rate hikes will be slow and gradual (compared to prior hiking cycles).
Source: Bloomberg, Reuters, AMP Capital
A “neutral” level of the Fed Funds rate (i.e. the rate that does not put upward or downward pressure on economy activity) is probably around 3%. But, the Fed Funds rate is only expected to reach this “neutral” 3% level in 2019 (at the earliest) - still some time away. The Fed is unlikely to wait this long to start normalising the balance sheet if interest rates are already being lifted. We think that after the next 0.25% rate hike expected in June (which would take the fed funds rate to 1.00%-1.25%), the Fed will start to communicate its intentions around its balance sheet before commencing actually reducing balance sheet assets from the end of the year. Current market expectations (based on the Fed primary dealer survey) are more dovish and indicate that participants expect balance sheet normalisation to occur when the Fed Funds rate is around 1.40% which they expect to occur in mid-2018 (vs our expectations of the Fed Funds rate reaching this level at the end of 2017).
What will balance sheet normalisation look like?
The value of Fed balance sheet assets is currently near $4.4 trillion, up from around $0.9 trillion before the financial crisis. The Fed balance sheet is likely to remain larger than its pre-crisis level because of i) higher trend growth in the demand for currency and ii) higher structural demand for reserves because of stricter regulation. A more “normal” level of balance sheet assets for the Fed to target is probably around $2.5 trillion.
Initially, the first step for the Fed will be to taper its reinvestment of maturing assets. This will achieve a lower level of assets on the balance sheet but in a way that does not cause a sudden negative impact on the economy & markets. Following this tapering of maturing assets, the Fed could then put its balance sheet on autopilot, with assets rolling off in a gradual and predictable way until the desired level of the balance sheet is reached. On our estimates, the balance sheet will reach its long-term “normal” level of $2.5 trillion in 7 years. If the Fed was to stop all reinvestment of assets suddenly (rather than tapering reinvestment) then the balance sheet would reach its long-term normal level in a shorter 4-5 year time frame.
The impact of balance sheet normalisation on the economy
The benefit in using two policy tools (interest rates and balance sheet) is that the impact can be different. The Fed Funds rate impacts short term money market rates more directly while changes to the balance sheet impact term premiums on longer-term securities. On our estimates, run-off of Treasury securities could average around $200-$300bn in 2018 which would boost 10-year yields by 10-12 basis points and equate to around 1.5 rate hikes (or 40 basis points). The bottom line from the Fed using both policy tools to impact the economy is that bond yields are likely headed higher from here. The key for the central bank will be to avoid a sudden tightening of financial conditions, but the indicators so far are good (see bottom chart).
Source: Bloomberg, AMP Capital
Globally, other central banks are unlikely to remove accommodative policy settings (through interest rates or balance sheet changes) for some time because there is still excess capacity across the major economies (see chart below). In Europe, economic data has been looking much better compared to a year ago. Manufacturing PMI’s, for example, are running in line with over 2%pa growth in 2017. But, underlying inflation is still too low in Europe. The ECB’s asset purchase program is due to continue until the end of the year, but if economic data continues to look good and barring any unexpected European elections results, the ECB is likely to announce a tapering of asset purchases later this year, to begin in 2018.
In Japan, growth still remains shaky and underlying inflation is well below the BoJ’s 2% target, so central bank asset purchases are likely to remain a key pillar of monetary policy for some time.
Source: Bloomberg, Reuters, AMP Capital
Implications for investors
Bond yields are headed higher from current levels, but the upward moves should be slow as central banks take time to normalise monetary policy, conditional on meetings their employment and inflation objectives. The start of balance sheet normalisation will keep upward pressure on bond yields and the risk is another “taper tantrum” as it approaches, which would cause volatility in equities. Investors need to watch Fed communication over the next few months to look for signs around how the Fed expects the normalisation process to work.
By Diana Mousina
Economist, AMP Capital
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