Michael Hasenstab, Ph.D.
Chief Investment Officer
Templeton Global Macro
The Opinion piece was first published in the Financial Times on December 29th, 2017.
In response to the global financial crisis, the US Federal Reserve took extreme but necessary measures to protect the American economy from collapse. It now faces a stark choice — act promptly and potentially cause significant disruption in the US Treasury market or act later and risk greater disruption across all markets.
One of the Fed’s tools to ease the crisis was buying US Treasury and agency debt. While this ballooned the Fed’s balance sheet from $900bn in 2008 to an unprecedented $4.5tn, it successfully provided liquidity to a starved system, lowered Treasury yields and boosted wealth through asset price inflation.
This $3.6tn money-printing exercise has financed approximately 20 percent of the government’s net borrowing per year since 2008.
The Fed has said it will soon begin the daunting task of unwinding this successful stimulus, doing so against a benign economic backdrop, including full employment, a low risk of deflation and a recapitalized banking system. It plans to cut $1.5tn-$2tn from its balance sheet by late-2020 by first scaling back, then ceasing to reinvest the proceeds of bonds and securities that reach maturity. One immediate effect of this will be to push Treasury yields higher.
Before the Fed’s stimulus, Asian export-oriented countries such as China accumulated massive US dollar reserves and recycled them into US Treasuries, effectively pushing down yields. As oil prices soared, crude-exporting countries pursued a similar strategy. Today, China’s reserve assets have dropped by $1tn from their peak and, with the drop in crude prices, oil exporting countries are selling foreign assets to fund burgeoning budget deficits.
Consequently, assets owned outside the US have dropped from their 59 percent peak in 2014 to just over 50 percent this year. New buyers will be needed to plug the Treasury’s financing gap. However, alternative buyers such as private investors (either corporates, banks, or investment funds) are all price- sensitive — meaning their demand varies according to the asset’s price — and they will only step up for higher yields.
Since the crisis, domestic, price-sensitive investors have funded about 35 percent of net US Treasury issuance. If foreign buyers maintain current rates of investment, private investment would have to reach 65 percent to make up the gap. If fiscal deficits keep growing, more price-sensitive buyers will be required to help prevent an upward explosion in yields.
Before the crisis, if the US economy was growing at 3 percent and inflation was 2 percent, then the 10-year US Treasury would yield around 5 percent — twice current levels. Interest rates may gradually normalize its. towards this but experience suggests these adjustments may be harsher than many anticipate.
Rising yields will trigger losses for bond investors who hold longer maturity investments. This will also be a precarious situation for index tracker funds, which have some of the highest exposure to falling prices. After that, the outlook is less predictable. Suffice to say, volatility is likely to increase.
By cutting interest rates to record lows, the Fed has driven investors in search of higher returns into riskier investments. This has pushed equities to record highs, credit spreads to near record lows and bond prices have been inflated by yields reaching all-time lows. This was the Fed’s original goal — to boost wealth and limit the growth slowdown — and it worked. Almost too well.
By artificially suppressing yields, the price of money, along with key metrics for valuing both financial and real investments, have been distorted. Many asset valuations are inflated since discount rates are artificially suppressed. It is only when policy measures taken to depress nominal interest rates are reversed that we will know the extent of the bad investments made in that artificial environment.
The Fed has one thing going for it to help prevent widespread damage while unwinding: a relatively bright economic picture — for now. Global and US growth remain healthy. Despite near-full employment (which is putting upward pressure on wages) and renewed credit growth, inflation has yet to exceed the Fed’s target.
Unwinding the stimulus in this environment should reduce the potential for damage in the Treasury markets spreading to riskier assets such as equities and credit. Failing to act now would mean delaying “the great unwind” until inflation and asset prices are even higher and at a later stage of the growth cycle — making the adjustment riskier. Taking away the punchbowl never makes partygoers happy but leaving it out all night can result in a far worse hangover.
Dr. Michael Hasenstab is executive vice-president, portfolio manager and chief investment officer of Templeton Global Macro.
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