The normalisation of Federal Reserve monetary policy and the impact on financial markets

In considering the process for rate normalisation it is instructive to revisit why the Federal Reserve used such extraordinary measures in the first place. This helps understand what is required to get to a position where quantitative easing is no longer needed and interest rates can be increased.

The developed world has been through an extended period over the last 20 years of lower and lower interest rates. A number of factors have led to lower yields. There has been a large increase in global savings, which have been channeled into buying bonds (exacerbated by the pegging of the Chinese currency to the US dollar). Another factor which may have had an even greater impact was the taming of inflation in the post-Volcker era, as a result of globalisation and the waning influence of large labour unions.

Lower rates meant that any asset which had a yield and which could be leveraged performed very well during this period. This led to housing bubbles and unsustainable leverage in the financial system. When the US raised rates in 2005 and 2006, the levels of debt that had been taken on became unsustainable and we had the global credit crisis. Balance sheet recessions caused by excessive leverage tend to be protracted and deep. The sudden deleveraging of an economy can have a devastating impact as lower asset prices lead to higher liquidations, which lead to lower asset prices.

Lower interest rates can help reduce the impact of deleveraging but the Federal Reserve couldn’t cut rates to below zero. As a student of the great depression, Bernanke realised that a new type of policy response would be required. He was aware that buying already depressed assets would stop the cycle of deleveraging and help to get the economy out of the crisis.

Once this first round of quantitative easing had underpinned asset prices and ended the chronic phase of the crisis, the Fed realised that the economy would need additional stimulus in order to repair itself. Low interest rates weren’t sufficient in an environment where excessive leverage in the banking system was part of the problem, and additional stimulus was decided on through another round of bond purchases. These further supported asset prices and helped households and financial institutions rebuild their balance sheets.

However, the strength of the recovery was anemic with unemployment slow to fall and US companies slow to invest given the continued uncertainty. Slack in the global economy also helped keep inflation under control. The Fed, with it’s dual mandate of both inflation and employment, felt that another round of quantitative easing would give the US economy further impetus. Whilst a new round of quantitative easing did have an effect, the size of the impact was less than was the case in the first two rounds. The Fed also realised that the long-term consequences were uncertain.

With US unemployment dropping steadily and continued economic improvement, it was a matter of time before the Fed decided to taper. Despite this, the market’s reaction to Ben Bernanke’s suggestion that bond buying be reduced was dramatic. The 10-year US treasury yield rose from 1.6% to 2.6% in a month as the market saw this as the first sign that rates would be normalised. The Fed was careful to manage expectations and when it announced tapering it was reduced by a relatively small amount ($10bn of the $85bn). Importantly fears that this would result in interest rate hikes were allayed by communicating that rates would be kept at zero until at least late in 2015.

The Fed continued on this path with a further reduction of $10bn announced at the most recent meeting at the end of January. The rate of taper reduction and eventual interest rate hikes continues to be dependent on economic data coming out of the US. While we continue to see improvement in economic data, it is not uniformly good, with the extreme weather having made reading data very difficult. It is however likely that the Fed will continue on its current path and may even accelerate the process it if the data becomes stronger. It will be acutely aware that markets are very sensitive to changes in the path.

What impact on markets?

Not surprisingly, the impact of tapering on US treasuries has been negative, with reduced buying likely to be less supportive of bonds. The Federal Reserve’s balance sheet now stands at over $4 trillion. Equity markets have performed better, with the improved economic environment trumping the prospect of less liquidity. The biggest impact has been felt in emerging market economies.

Bond purchasing has had a significant dampening effect on bond yields in the developed world and this precipitated the so called ‘search for yield’ with investors going into higher yielding assets like credit and emerging market bonds.

The prospect of rate normalisation has caused these investors to take stock and sell some of the investments acquired over the last few years.

South Africa with its open bond markets and reliance on foreign portfolio flows to fund the trade balance has been affected and is likely to continue suffering as the process unfolds.