At our Investment Quarterly last week, we identified two key issues we believe will drive asset prices during the rest of this year: the Fed’s balance sheet unwind and whether the recent weakness of inflation, particularly in the US, will persist. A sea change is already underway; after almost a decade of extraordinarily easy monetary policy and trillions of dollars’ worth of QE, global central banks are shifting into reverse gear. Whilst central banks and market participants understand the effects of rate hikes, there are no precedents for central bank balance sheet reduction of the scale we are about to see. If rising central bank balance sheets lifted asset prices, surely shrinking balance sheets should also act in reverse? To complicate matters further, inflation has been surprisingly weak, certainly for this stage of the economic cycle when labour markets are tight. Are central banks committing a policy error tightening in the face of weak inflation, or is higher inflation just around the corner?
Global growth, particularly in the developed world, is running at close to its fastest pace since the financial crisis and central banks are mindful not to overstay their welcome and allow the trillions of dollars of liquidity that they created to become a source of market excess and disequilibrium. However with inflation still below target and to allay concerns about policy error, senior central bankers including Draghi and Carney have argued that from the growth and output gap perspective alone, some recalibration is required merely to keep the stance of monetary policy unchanged.
Central bankers have been at pains to communicate clearly and to provide forward guidance to markets because they understand that after emerging from the deep financial crisis, confidence remains fragile and a loss of market confidence can unravel years of healing. Whist we acknowledge that unwinding trillions of dollars of QE is very unlikely to happen without trouble (this extraordinary period of low market volatility and higher asset prices cannot go on forever), we are confident that the start of the Fed balance sheet unwind can proceed without too much market disruption. This is because of forward guidance and clear signalling which are very much part of a modern day central banker’s toolkit.
Each episode of QE was well telegraphed and the chart above shows that on average, markets rallied ahead of the actual start of QE purchases (defined above as Day 0), and then reversed not long after. In other words, buy the rumour/announcement and sell the fact. Likewise, Treasuries sold off sharply on the taper announcement, but almost to the day when the taper actually started, began to rally back. In this instance, the market sold the rumour/announcement and bought the fact. Of course we must be careful not to attribute all of this market behaviour to signalling and guidance. Weaker growth and weaker inflation prospects that drove central banks back into doing more QE were also very important factors.
Another reason why we are not too fearful of the Fed balance sheet unwind in the near term is that the ECB and BoJ are continuing with their QE programmes and on an aggregate basis, global QE flow from major central banks will stay positive until the second half of next year. In addition, FX reserves are rising again. This plus the ongoing QE money that is still being created by global central banks will, for a while, offset the balance sheet reduction from the Fed until they themselves start to slow down their purchases and ultimately also go into QE reversal. We also note that should there be signs of trouble, both the ECB and BoJ have given themselves room to slow down or even reverse their tapering, particularly if the BoJ’s yield curve control policy (anchoring the 10-year JGB yield at around 0%) is tested.
We also debated at length the recent absence of higher US inflation. Here, we knew we had to be careful not to simply extrapolate recent weakness in inflation as some measures, including the August print, suggest that inflation may already be bouncing back. Our studies tell us to expect some more near term rebound in inflation, although longer term inflation headwinds may keep the recovery in inflation just shy of the Fed’s 2% target. For cyclical reasons, we have good reasons to expect higher inflation: whilst the slope may have flattened, the Phillips Curve’s inverse relationship between labour market slack and wage pressures appears to still hold, not just in the distant past, but also in recent years.
In addition to wage pressures, other drivers of inflation that have recently been weaker, including shelter inflation, already show signs of stabilization at around the 3% level. Furthermore, the weakness in the dollar since the start of the year may give imported inflation a little boost.
Against that, we recognised that recent weakness in inflation has been widespread across many sectors and much of the structural disinflation that we have observed for a while now may persist during the foreseeable future. Advances in technology are widely acknowledged to have weighed down on inflation and with real investments in intellectual property products and information processing equipment steadily rising in the US (to more than 6.5% of GDP currently), technological advances will continue to push down on inflation in the years to come. In addition, whilst we have recently seen sharp negative contributions from wireless telephones, many other sectors including education, cable and satellite TV, and hotels are either facing or will face similar pressures. A further increase in the online share of total retail sales in the US (still low compared to the shares observed in other countries) will further increase price transparency, competition and drive comparable prices towards their lowest common denominator.
Much more was discussed at the Investment Quarterly, including the outlook for individual sectors such as high grade and high yield corporates, as well as EM FX and debt, but these are not topics for today’s article. In terms of the macro outlook, we are mindful of the uncertainties associated with the Fed’s balance sheet unwind over the long term and signs of any market unease will be closely watched in the quarters and years to come. However, over a shorter time horizon from now till the end of this year and into the start of next year, we believe that strong global growth, clear signalling of intentions from central banks and some recovery of inflation to more normal levels (but still shy of central bank targets) point us towards the view that the start of the Fed’s balance sheet re-normalization programme, deliberately calibrated to be slow, can occur without too much fanfare. Higher term premium will edge the yield on 10 year US Treasuries gradually higher, and stronger growth and some recovery in inflation will allow the Fed to hike again in December.