Macro Focus: Fed exits…lessons from history

by: Peter de Bruin

Macro Focus: Fed-exits...lessons-from-history.pdf ()

We assess the implications of the Fed exit for the economy and financial markets

Ever since Chairman Bernanke hinted that the central bank will start to reduce the pace of asset purchases later this year, tapering concerns have driven up long-term Treasury yields by around 130bp, while the rally in equity markets has paused. As such, investors have started to fret over whether the coming exit cycle – with the Fed first winding down its QE programmes and, at a later stage, hiking rates – might dampen or even derail the economic recovery. In this research note we assess what lessons we can draw from the past, as well as whether this time will be different.

Economy and growth assets perform well in the run up to and during tightening cycles

The good news is that of the seven tightening cycles that we have identified, six continued to see ongoing strong GDP growth in the two years after interest rate expectations started to build. In addition, private employment grew, on average, by more than 200K per month. This happened even though 10-Y interest rates rose by an average of 160bp in the 180 days after rate hikes came to the fore. Against this background, typical growth assets such as equities and commodities did well. The dollar and gold also saw a positive performance, though admittedly there were large differences between cycles.

More risks this time, but they look manageable

Obviously, this is no ordinary monetary policy cycle. The Fed’s balance sheet has ballooned from 0.8 trillion dollars to around 3.5 trillion dollars, while Chairman Bernanke has stressed that the Fed will not sell its assets. This implies that the created liquidity will remain in the financial system for a considerable amount of time, which makes the consequences of this tightening cycle more uncertain. However, we think that they are ultimately manageable. This is because the Fed can control the federal funds rate, even in an environment of excess liquidity, by raising the interest rate it pays on excess reserves. Although tapering concerns have led to some unwinding of capital flows that had supported emerging markets and commodity markets, there do not appear to be bubbles in financial markets more widely, while emerging markets have better fundamentals this time. Nor are there signs that excess liquidity is flowing too rapidly into the economy in the shape of a credit boom, while inflation looks set to remain subdued.

We expect the economy to do well and investor sentiment to recover

Our base line scenario looks pretty much like the typical tightening cycle, with the US economy set to accelerate in coming quarters, while equities should also continue to do well, and the dollar should outperform on the back of strong fundamentals, higher US rates, and an attractive valuation. Meanwhile, Treasuries – and to a lesser extent corporate paper – should be unattractive investments as longer-yields are set to rise. That said, unlike in the run-up to previous tightening cycles, commodities – especially gold – are likely to face headwinds. The risks to this benign view is that inflation comes in to view – either because liquidity starts to rapidly flow into the economy or because there is less spare capacity than currently judged – forcing the Fed to tighten more quickly than desirable.