In the latest edition of “Global Macro Shifts,” the Templeton Global Macro team examines the plans to start shrinking the US Federal Reserve’s (Fed’s) balance sheet and the potential impacts to financial markets. The team briefly outlines the global economic backdrop, then reviews the monetary policy normalization challenge, contrasting the set of expectations held by markets with the three factors it sees at play.
The Fed has unveiled plans to start shrinking its balance sheet, which has more than quadrupled in size since the global financial crisis (GFC). The multi-year massive expansion of the Fed’s balance sheet has had a recognized powerful effect on asset markets—lowering yields and flattening the yield curve. Yet investors now seem to expect that the reverse process will have little impact, if any.
We disagree. We believe three factors have the potential to push bond yields higher; any single one could be sufficient to push yields well beyond current market expectations, and we see very little chance that none of them will materialize.
First, as the Fed reduces its purchases and the US Treasury increases supply to finance the ongoing fiscal deficit, new buyers must step in to keep the market for US Treasuries (USTs) in equilibrium. Our analysis shows that the burden will fall disproportionately on domestic, price-sensitive buyers like banks, mutual funds, pension funds and corporations. For these buyers to increase their demand, UST prices must fall and yields rise.
Second, as the Fed unwinds its balance sheet in a gradual manner, banks’ excess reserves will remain extremely high for the next few years. A well-entrenched and strengthening economic recovery will give banks a growing incentive to increase credit supply—all the more so as financial regulations will likely be eased over the coming year. With stronger global growth and bolstered confidence, credit demand will also likely rise. This underscores the risk of a faster-than-expected acceleration in credit, which could further stimulate growth and raise inflation.
Third, wage and price pressures are unlikely to remain muted as the US economy, having reabsorbed all economic slack, keeps growing above potential—and the global economy with it. We find arguments that the wage and price Phillips curves1 have permanently flattened unconvincing. Moreover, both wage and price trends have a strong global component, and inflationary trends in the global economy are now likely to get stronger.
To assume that none of these three factors will come into play would be, we believe, foolhardy. As the Fed unwinds its balance sheet, we should ask not whether yields will rise, but how much faster and higher than market expectations.