How did we get there?

In late 2008, the US Federal Reserve Bank (Fed) began large-scale purchases of financial assets, mainly US Treasury securities and US government-backed, mortgage-related securities to help stabilise the financial system and support the economy throughout the great recession.

For six years, the Fed conducted its asset purchase programme, dubbed quantitative easing or QE for short, which ended October 2014, and the Fed’s balance sheet ballooned fivefold to approximately US$4.5 trillion over the six-year period. It has been maintained at that size through re-investment of principal payments and maturing securities.

The balance sheet consists of about US$2.5 trillion in treasuries and US$1.8 trillion in mortgage-backed securities.

BENEFIT OR CONSEQUENCES

The overall benefits of the Fed’s QE programme remain debatable. Some people argue that QE provided very few gains for the mainstream economy – evident in ongoing tepid growth in GDP and wages, but provided great support to “Wall Street” through elevated asset prices such as equities.

Whether the benefits from QE were equally shared or deserved, it is undeniable that the US economy at the time needed some form of stimulus to get through the great recession, which saw US unemployment reaching as high as 10 per cent during the 2007 – 2009 recession period.

The economy is currently within the longest expansion phase in recent history, and the unemployment rate is at 4.3 per cent — a level which suggests that the US economy is currently operating at or near full employment.

Bond yields are at historic lows and equity markets are at or near historic highs. Emerging market bonds and equities have also benefited from the vast injections of liquidity to the global financial system emanating from the FED’s QE programme, as well as those from other major central banks such as the European Central Bank (ECB) and the Bank of Japan (BOJ).

WHY IS SHRINKAGE NECESSARY?

Many people argue that the unprecedented policies of major global central banks with such low interest rates and large asset purchases have distorted the yield curve and created asset bubbles or have the potential to do so, and therefore a return to some form of policy normalcy is essential.

In addition, as economic conditions continue to improve, as evidenced in the labour and housing markets and the broader ongoing economic recovery, the Fed faces growing pressure to address the size of its balance sheet, having already started the process of normalising interest rates.

Moreover, reducing the size of the balance sheet while the economy is still healthy allows for more balance sheet policy space in the future, should the need arise.

WHAT’S THE EXPECTED PROCESS?

In order to mitigate the potential adverse impact to financial markets from reducing its massive balance sheet, the Fed has opted to simply allow the bonds to run off naturally as they mature, rather than seek to actively sell them into the market.

As such the Fed will begin to reduce the amount it re-invests from maturities by an initial amount of US$10 million per month, which will be gradually increased until it reaches US$50 million per month.

At its last meeting in July the Fed stated the process will begin soon, which market participants interpreted to mean that an announcement will be made at the next meeting in September with a start of October.

The entire process is expected to last for several years, and the balance sheet is expected to be reduced to a level of around US$2.5 trillion.

WHAT ARE THE POTENTIAL CONSEQUENCES FOR INVESTORS?

Investor opinions are sharply divided on the matter, ranging from a minimal impact to catastrophic, and ultimately causing a recession.

Those who argue that it will have a minimal impact, in part, underscore the point that the current gradual approach to interest rate hikes has so far had very little impact on tightening financial conditions, and thus continue to support asset prices in a relatively strong global economy underpinned by low inflation. The Fed’s telegraphed gradual approach to right-sizing its balance sheet is therefore expected to minimise the impact.

On the other spectrum, people suggest that the Fed’s twin policies of low interest rates and balance sheet expansion created inflated prices in some assets, and therefore any attempt to remove such support – be it gradual or otherwise – will cause significant downturn in prices of those assets. For instance, they posit that equities will be hard hit, having risen in excess of 250 per cent (since their lows during the crisis) mostly as a result of central bank interventions.

In addition, they suggest that yields will rise faster than currently anticipated, as other major central banks will sooner rather than later begin a similar process.

Emerging market bonds and equities are also expected to decline due to relatively tighter global financial markets and the flight to the quality as interest rates rise in developed markets. The inverse relationship between yields and prices will undoubtedly have an adverse impact on bonds in general, particularly longer-dated bonds if yields rise.

HOW SHOULD INVESTORS POSITION TO REDUCE RISK OR BENEFIT?

It is uncertain what the overall impact of the Fed balance sheet reduction will be. Additionally, to date the Fed will only begin this process if it is confident that the economy is strong enough to accommodate it. They have successfully increased interest rates on four occasions without tightening or disrupting financial markets, and the best-case scenario is for a similar outcome.

It does, however, seem plausible that the removal of the stimulus which supported asset prices over the years is bound to have some form of impact. Uncertainty invariably causes investors to be cautious, and therefore some amount of risk elimination or reduction may be warranted.

These could range from moving from riskier asset classes to relatively safer ones to not only crystallise profits but also preserve principal, to reducing interest rate risk by reducing duration in portfolios.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm