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Will monetary policy normalization ramp up market volatility?
12/13/2017 7:25:50 PM
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By Fund Library News Wire  | Tuesday, November 28, 2017


 



By Joe Davis, Global Head, Investment Strategy Group, Vanguard Group, Inc.

As interest rates in Canada trend upward, monetary policy in the United States is likewise returning to normal after a decade of extraordinary measures to stimulate economic growth. As Vanguard forecast last year, the United States Federal Reserve is entering on “Phase Two” of its path to policy normalization: the reduction of its balance sheet of about $5.7 trillion in securities (mostly U.S. government bonds) acquired as part of the Fed’s economic stimulus efforts during and after the global financial crisis. ( Figures cited are in Canadian dollars, at October 2017 exchange rates. )

Our anticipation that 2017 would mark the transition from Phase One (raising the U.S. federal funds rate, an influence on interest rates in the U.S., Canada, and worldwide, from 0%-0.25% to 1.00%-1.25%) to Phase Two was based on a view that the U.S. labour market would continue to gradually tighten this year and financial conditions improve, even without a strong rebound in inflation. That outlook has been generally on point.

Shrinking the Fed’s balance sheet

Most market observers now anticipate an appropriate, gradual, and smooth unwinding of the Fed’s balance sheet that is unlikely to give the financial markets pause. I agree with “appropriate” and “gradual.” The third adjective, “smooth,” is what worries me.

To be fair, the Fed has taken a number of steps to mitigate market impacts:

* A transparent forward-guidance strategy.

* A slow schedule for unwinding – initially by only about $7.7 billion per month of U.S. Treasury notes and $5.3 billion of mortgage-backed securities (MBS). This will eventually rise to about $38 billion per month and $26 billion per month, respectively, compared with average daily trading volume of more than $635 billion in the Treasury market and more than $255 billion in the MBS market.

* An intent not to sell securities but simply to decrease the amount it reinvests from maturing securities.

* A likelihood of settling on an optimal balance-sheet size that is significantly higher than pre-crisis levels (we expect it to be in the $3.8-$4.5 trillion range, up from about $1 trillion).

Phase Two risks

To be clear, we believe that the Fed’s course of action in beginning to taper its balance sheet is appropriate given the state of the U.S. labour market and the strength in financial conditions. But I believe we should all be prepared for a potential uptick in volatility during this monetary policy phase. No major central bank has yet successfully reversed quantitative easing, or QE (the Bank of Japan’s balance sheet is higher today than a decade ago), so we shouldn’t take for granted that this will be easy and uneventful.

With the balance sheet at an unprecedented size (see chart above), passing this second milestone without materially affecting financial conditions or roiling the markets could well prove a bigger challenge for the Fed than starting to raise rates. Because the Fed’s QE programs helped to stimulate asset prices and the search for yield (sometimes clinically referred to as the “portfolio rebalancing effect”), I believe it is reasonable to expect some choppy waters in the months ahead as some of the oxygen is let out of the system.

Where we’re headed

The Fed would clearly like to return to more normal monetary policy conditions and has taken pains to lay out how it expects to get there. Phase Two is part of that plan. Most believe that the well-telegraphed tapering of the balance sheet will be a nonevent. Many economists, including those at the Fed, see Phase Three – resuming the course of rate hikes – occurring as early as December 2017.

Our view is different. For some time, we have felt that Phase Two would be followed by an “extended pause” in rate hikes, leaving short-term rates near 1.25% through the middle of 2018, if not longer. Whether our long-held view proves correct will depend on a range of factors, including the pace of future inflation, how quickly the unemployment rate declines below 4%, and how supportive financial conditions are to the economic recovery.

Our outlook

The Fed is unlikely to raise the federal funds rate as it begins tapering its balance sheet. Nonetheless, Phase Two should still be viewed as a “tightening” in monetary conditions as it will reduce total Fed balance sheet assets following several rounds of QE. To my mind, QE has been a factor in the strong performance of various investments over the past several years, including equities and bonds. Risk appetites, as measured by cash flows, have been strong across the globe, and investors have been rewarded for bearing that market risk.

But the combination of fully valued asset prices and low levels of market volatility has generally not been indicative of strong future returns. In a future blog, I will address the question of whether (and by how much) the U.S. equity market has become overvalued.

Needless to say, we continue to maintain a guarded market outlook at Vanguard, and we urge investors to stick to their balanced, long-run plan whether or not my worries materialize. Let’s hope I am wrong.

Joseph H. Davis, PhD, is a Vanguard principal and the global head of The Vanguard Group, Inc.’s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics. As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group, which oversees more than US$700 billion in assets under management.

Notes and Disclaimer

© 2017 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Insights” page of the Vanguard Group, Inc.’s website. Used with permission.

Important information

The views expressed in this material are based on the author's assessment as of the first publication date (November 2017), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.

While this information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of this information or any results from its use.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.

Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

 
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