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
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.
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
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