Global Macro Outlook July 2017 - World Federation of Young Investors

Taper Tantrums: Shrinking the Fed’s Balance Sheet

  • A major theme that has dominated Global Markets in the past month is the notion of the U.S. Federal Reserve trimming its balance sheet going into the second half of the year. As we closely examine speeches from the Federal Reserve at the end of June, it could be interesting to consider what such a course of action would mean for global financial markets.
  • Generally, we can understand the Fed’s consideration of reducing its balance sheet as synonymous with the theme of normalising interest rates. During QE2, Ben Bernanke characterised the $600 billion in asset purchases as equivalent to a 75 basis points cut in interest rates. Thus, given the recent rhetoric of raising interest rates, it makes sense to offload some of the assets in the Fed’s balance sheet as a complement to raising the traditional Fed Funds rate. However, where it becomes interesting, are the repercussions that this may have on equity, bond, and currency markets for private investors.

 

  • On the chart below, we can see a startling level of correlation between central bank balance sheets and equity markets worldwide. As the Fed increased its balance sheet from $1 trillion pre-GFC to approximately the $4.5 trillion that is has today, so did we see the dramatic rise in stock markets. Not only that, but we have also seen businesses come to rely on almost of decade of cheap credit sponsored by central banks; therefore, as the Fed starts to withdraw this liquidity, and as it attempts to shrink its balance sheet, it is likely that the stock market could react negatively to this process.

    Source: Seeking Alpha
  • Another asset where this may have serious repercussions is of course, the US Dollar. Historically, as we can see in the period between 2014 and 2015, the US Dollar experienced a massive spike simply on talks of tapering by the Fed. Thus, as the Fed plans to withdraw dollar liquidity from the global financial system, what we could potentially see is massive demand for the USD in overseas markets. Further considering the bill proposed by President Trump that will force the private sector to pull back approximately $2.5 trillion in corporate profits from overseas, it is likely that we will see further strength in the dollar going into the end of the year as the Fed implements this programme.

 

  • Finally, the bond markets are equally likely to experience a consequential shift owing to this tapering programme. The traditional narrative in Fixed Income markets has been that QE lowered yields across the curve, which created a ZIRP environment that benefited global financial markets. However, if we carefully look at the spreads between ten year yields and CPI, it was stable throughout the QE programme – in fact, Treasury Yields increased at every QE. Thus, as we look for the reversal of this process, it is likely that bonds markets will experience lower, not higher, yields.

 

  • To sum up, the notion of the Fed tapering its balance sheet assets is likely to create serious shocks to several asset classes. If it truly is the case that the Fed decides to cut back on its balance sheet in the coming months, private investors could potentially play it by being short equities, long bonds and long the US Dollar.
    US Dollar Currency Index. Created with TradingView

    By Nicholas Tan Wei Hong