Entering uncharted waters

This article first appeared in The Edge Financial Daily, on September 25, 2017.
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KUALA LUMPUR: The US Federal Reserve (Fed) will kick-start the unwinding of its US$4.5 trillion (RM18.9 trillion) balance sheet next month — barely one week away from now.

In a nutshell, the move is the reverse of the three rounds of quantitative easing (QE), which was the measure then to inject liquidity by buying debt papers on the open market the Fed has taken since the onset of the Global Financial Crisis (GFC) in 2008.

Similarly, it is just like the QE, no one, including economists and policymakers, knows for sure how the move would impact the world’s financial markets that have been used to ample liquidity for nearly a decade. 

Stronger greenback weaker emerging currencies

A fund manager told The Edge Financial Daily that the pace of the reduction in the balance sheet will be crucial as this will be a significant change to the global financial market that has enjoyed easy monetary policy for that long.

According to him, the biggest risk to emerging markets, including Malaysia, is the outflow of foreign fund that would trigger sell-off in government bonds and the equity market.

“In layman terms, the unwinding of the balance sheet of such a huge amount means that there will be no more or reduced bond purchases in the markets, thus bond price will come down and yield would go up, leading to higher borrowing cost. Carry trade will then become unattractive. The US dollar is expected to strengthen against the currencies in emerging markets,” he added.

Another analyst concurred that the “markets don’t know what to expect” but believe the flow of money will trigger a negative reaction in the equity market.

“I think the markets might take a knee-jerk effect in the short term,” he said.

Hussein Sayed, chief market strategist at FXTM, noted that before the announcement from the Fed on the decision to start unwinding its balance sheet, the market was anticipating interest rate to remain low, if not lower, for the rest of this year.

“The expectation [of low interest rate] was due to persistently low inflation and negative impact of hurricanes Harvey and Irma on economic growth. Instead the Fed decided to look past low inflation and said that the harm of hurricanes would have no lasting economic impact. This has forced market participants to adjust their expectations for an interest rate hike in December, from a chance of 50% to above 70%,” he said.

Slow and uneventful 

The Fed’s reinvestment policy has been in place since August 2010. The size of the balance sheet reduction such as this has never been done before so this is unchartered territory. The American policymakers have consistently been communicating to the markets that the committee would be prepared to resume reinvestment in principal payments received on securities held by the Fed if a material deterioration in the economic outlook were to warrant a sizeable reduction in the committee’s target for the federal funds rate.

The fund manager opined that it’s an assurance that the trimming of its balance sheet will be slow and uneventful. “The pace will be like a trickle, about US$10 billion a month to start with, rising eventually to US$50 billion. But to be honest, flow of money will definitely be affected, and the impact will be felt more for the emerging markets,” he commented.

Affin Hwang Asset Managementsenior investment analyst Jeffrey Hu pointed out that while some are rightfully anxious about this perceived squeezed liquidity and a possible end of the easy-money era which has been keeping the economy afloat since the 2008 GFC, however, markets aren’t necessarily holding their breath or bracing for any large corrections.

He concurred that the unwinding exercise will be gradual in nature, in line with the Fed’s mandate to placate markets and ensure that the economy continues to chug along at a moderate pace of growth.

According to the Fed’s June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans, the initial reduction caps of its balance sheet will be gradually unwounded by US$6 billion a month for US Treasuries and US$4 billion per month for agency debt and mortgage-backed securities (MBS). 

Subsequently, it then follows a step-up schedule to increase the caps by US$6 billion for the Treasuries and US$4 billion for MBS by every three months respectively.

Eventually, after a year from inception, the Fed is then expected to increase to maximum reduction caps to US$30 billion per month for US Treasuries and US$20 billion per month for MBS. Currently, the Fed’s total outstanding US Treasuries stand at about US$2.5 trillion and US $1.8 trillion for MBS.

Affin Hwang’s Hu commented that the Fed’s intention is to keep the exercise as “boring” as possible in terms of market reaction.

“On our investment positioning, we remain cognisant of the surrounding geopolitical risks in the region stemming from a more unpredictable North Korean regime, as well as the gradual reduction of global liquidity through unwinding exercises by both the Fed and European Central Bank.

“Tone in credit market continues to be firm, as we see stability in current levels with rates mainly grinding sideways over the near term. We continue to favour investment-grade over high-yield bonds and aim to keep durations low within four to five years within our portfolios due to uncertainty of the US Treasuries trajectory,” he said.

On whether the fund flow of money globally will affect emerging markets, such as Malaysia, with what is dubbed as the “quantitative tightening” with the Fed likely to raise interest rate in December along with the beginning of the trimming of its balance sheet, Hu thinks that global fund flows should still remain supportive.

“As long as the Fed remains gradual in its rate hike normalisation, which currently still seems to be the case, then global fund flows should still remain supportive for emerging markets,” he added.

US rate hike in November?

Equity analysts pointed that the US inflation has likely bottomed after five consecutive months of downside surprises up to July this year and the recent August Consumer Price Index (CPI) reading signals firmer inflation numbers. 

A core CPI at about 1.7% to 1.8% year-on-year going into December this year seems like a reasonable expectation. Consensus view is expecting another round of hike in December this year with US Treasury yields to remain stable to marginally higher from current levels.

UOB Global Economics and Markets Research, however, did not rule out the possibility of an earlier rate hike in November.

“The market is currently pricing in a very low probability for a November hike but as we had seen early this year, the Fed [through its senior officials speaking in public forums] could shift expectations very quickly,” Alvin Liew, senior economist at UOB said.

Recall that the probability of a rate hike in US Federal Open Market Committee meeting in March jumped from less than 30% on Feb 21 to more than 90% on March 7 — one week before the meeting.

“So for now, while our base case remains for a rate hike in December, we are not ruling out an earlier move in November yet. And we believe we will probably get more clarity on a “preemptive” November rate hike by mid-October,” he noted.

Possible change of guard adds uncertainties

The timing for the trimming of the US balance sheet has raised some eyebrows though especially with some changes expected in the Fed’s leadership as its vice chair, Stanley Fischer, is set to step down in the middle of next month, while Fed’s chair Janet Yellen’s term is coming to an end in early February next year.

Fischer’s resignation would create a vacuum within the Fed’s board of governors, giving a chance for US President Donald Trump to reshape leadership within the central bank. Consequently, this may create uncertainty over future policy direction.

Fishcher has been known for his centrist voice compared to Yellen, more for her dovish tone.

On this, Affin Hwang’s Hu reckoned that it might only marginally lead to a more dovish US Fed because a leadership vacuum could lead to less consensus at the Fed to go ahead with any rate hikes.

“Another angle to look at this is that Fischer has been more on the centrist side of the dovish-hawkish spectrum, so Trump could fill the position with someone a lot more dovish. But the economic and inflation outlook should still be the most important factors impacting the Fed’s monetary policy outlook,” he said.

It could be argued that Trump’s preference for a weaker US dollar for a longer period means he might appoint more doves to fill the leadership vacuum when Yellen’s term comes to an end early next year but economic and inflation outlook should still be the main drivers of any monetary policy decision at the Fed, Hu noted.

Most market analysts and economists view that the Fed’s current rate and balance sheet normalisation plans and policies will remain intact regardless of whether Yellen would remain as the Fed’s chair.