Unwinding Quantitative Easing (QE)—Will it Unwind the Markets?
Q: Central banks have remained a focus of global markets. Can you give us an update on what different central banks around the world are telegraphing?
Michael Hasenstab: There has been a lot of focus on the speed and extent of interest-rate hikes out of the US Federal Reserve (Fed), but I think there hasn’t been enough focus on what happens when the central bank starts to unwind its balance sheet. I think the United States will be the first central bank to unwind, with Europe following suit at some point. Japan isn’t really in a position yet to be unwinding though, in my view. Even if the Bank of Japan stops QE, I believe it will still target the 10-year yield to keep it close to zero.
There is a concern that the Fed has never unwound such a large amount of assets before, and the likelihood that there are no disruptions is theoretically possible, but seems pretty unlikely in practice. We have to be ready for that. And, it’s not just what the Fed is doing in terms of its balance sheet that is important. We have a lot of deregulation happening, and there could be fiscal spending coming as well. It’s a pretty complicated US landscape.
Christopher Molumphy: To Michael’s point, central bankers have quite a task ahead of them. The Fed started with a balance sheet of less than $1 trillion, and now it’s up to $4.5 trillion, so it has some work to do to unwind it. I think the Fed has done a reasonably good job recently of trying to telegraph its intentions. But as Michael noted, it’s a big action in front of us, and there are a lot of things that could go wrong.
Ed Perks: I think another thing that’s relevant is the possible transition we could see at the Fed. Fed Chair Janet Yellen’s term is scheduled to end early in 2018, so I think the markets will increasingly be focused on the Fed’s potential path under new leadership if it seems likely she won’t continue on.
Christopher Molumphy: While Yellen isn’t totally out of the running for a second term, at this point, it seems likely that there could be a new Fed chair. When we think about monetary policy going forward, the impact of that transition is a question mark. As Ed pointed out, we are in the later innings of Yellen’s term, so we will need to see some transition communications sooner rather than later.
Michael Hasenstab: In my view, it might be a good thing to have someone from the market side at the Fed’s helm. But back to US monetary policy and the implications, I think it’s pretty simple. I believe interest rates need to go higher. The United States now has full employment, economic growth is at or above potential and the output gap has closed. Inflation has not come into the picture yet, but it’s probably just a matter of time as it’s a lagging indicator. All of these factors point to a 10-year US Treasury yield that should be higher than 2%.