Don’t fight the Fed’s balance sheet taper
Why paring the central bank’s holdings has investors on edge
The U.S. Federal Reserve’s move to trim the size of its bond holdings has exacerbated recent declines in prices for risky assets around the world, investors say.
The central bank has scaled back its mountain of Treasury and mortgage debt by $111.9 billion (all currency US) since the policy was announced in September. More than half the reduction has taken place since the end of March, and the process of withdrawing money from the economy is scheduled to reach $50 billion per month in October. The Fed’s balance sheet swelled to $4.5 trillion in the wake of the financial crisis as it bought government and mortgage debt in hope of kick-starting growth. Now, with the U.S. economy on firmer ground and unemployment at its lowest in decades, the Fed is removing that stimulus by allowing some of its holdings to mature without reinvesting the proceeds.
Some analysts said the moves heightened volatility that spread through government bond markets this month due to economic problems in countries such as Brazil, South Africa and Turkey. Currencies of those countries have declined 12%, 16% and 13%, respectively, since the end of March.
In turn, worries about those countries fuelled demand for safer assets including Treasury debt, especially since the Fed has also been raising shortterm rates in the U.S.
“The markets are more discerning” about what kinds of risks are acceptable, said Robert Tipp, chief investment strategist at PGIM Fixed Income. The disruptions from the shrinking of the Fed’s balance sheet “are going to be felt in proportion to” the weakness of each market.
An added worry: Besides balance-sheet actions, the Fed has also been raising short-term rates. Some investors believe it is natural for assets at relatively elevated valuations, such as stocks, to come under pressure when the Fed is in tightening mode. That is especially true near the start of the ninth year of an economic expansion.
Several investors expect the shift away from risky global assets to become more pronounced as the Fed over time reinvests in less and less debt. Meanwhile, the European Central Bank said last week that it would stop buying bonds outright in December, although it will reinvest proceeds of bonds that mature in its portfolio.
Shrinking the Fed’s balance sheet will reduce foreign purchases of emerging markets stocks and bonds by about $70 billion combined in 2018 and 2019, according to estimates from researchers with the International Monetary Fund. That is a contrast to average annual inflows of $240 billion since 2010.
Those inflows occurred as the Fed was expanding its balance sheet, which encouraged investors to take on more risk.
Now that the trend is going the other way, the effect of the Fed’s move to shrink its holdings has caught the attention of some foreign policy makers. These include the heads of the central banks of Indonesia and India. Indonesia raised interest rates twice in May, in part to support its currency against a rising U.S. dollar, while India raised rates in June. The Bank of India’s governor, Urjit Patel, urged the Fed to slow down.
Mr. Patel said in an opinion piece in the Financial Times that the Fed’s balance-sheet reduction was making it harder for emerging markets to handle a dollar liquidity squeeze. This is being driven largely by U.S. fiscal policy — namely, the increase in Treasury debt issuance to cover widening federal budget deficits. At the same time the deficit is rising, the Fed is shrinking the supply of dollars, contributing to a shortage.
Some analysts blame recent volatility on the dollar’s rise. Many investors had bet on the U.S. currency declining in value against the euro, furthering a trend seen in 2017. That hasn’t worked as planned this year, compelling investors to reverse trades as Europe’s growth has lagged behind the U.S.
Tighter policy from the Fed has been “ultimately the most important factor,” in the performance of global markets, said Holly MacDonald, chief investment strategist at Bessemer Trust, which is overweight U.S. securities. “Right now there’s not a whole lot of compelling opportunities in global fixed income.”
As the Fed continues to shrink its bond portfolio, “this is probably the biggest risk,” Ms. McDonald said. Investors are looking over their shoulders because shrinking liquidity helps intensify market spasms.
“It’s underlying the backdrop of the volatility we’re seeing this year,” she added.