WEEKLY E-MAIL

25 September 2017

QUANTITATIVE EASING – THE LONG UNWINDING IS SET TO BEGIN

By James Malliaros

With many of the larger advanced economies showing moderate growth, central bank policy makers are beginning to consider when to phase out the aggressive stimulus measures that were put in place during and after the Global Financial Crisis (GFC).

The one big question looming over financial markets is how they will likely react when central banks do start to unwind as happened last week with the US Federal Reserve (Fed) confirming that it will begin “balance sheet normalisation” next month. In addition it has signalled its intention to raise interest rates in December and again three more times next year. The concern is that the Fed has never unwound such a large amount of assets before, and the likelihood that there are no disruptions is possible, but seems unlikely in practice.

Balance sheet normalisation basically involves reducing the balance sheet of central banks back to more normal levels after it was boosted by post GFC “quantitative easing” (QE) or bond buying using printed money. The process of reducing the balance sheet is achieved not by selling bonds, but by slowing the reinvestment of maturing bonds.

Central banks have quite a task ahead of them. As can be seen graph below, the Fed started with a balance sheet of less than $1 trillion just before the onset of the GFC and now it’s up to $4.5 trillion, so it has some work to do to unwind it. With the recent announcement, it is expected that the Fed’s balance sheet will have fallen below $US3 trillion by early next decade.

Although the United States is the first central bank to unwind, it is expected that Europe will follow suit at some point soon, with Japan still some time away from starting to unwind its balance sheet.

The Fed’s move to start balance sheet normalisation is a momentous shift and shows how much stronger the US economy has become in recent years. 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.

The implications are that as interest rates in the United States start to normalize, higher US rates combined with stable rates in Japan or Europe should lead to a stronger US dollar. This in turn should help reduce the rising pressure on the value of the Australian dollar, which in turn should be welcome news for the Reserve Bank of Australia, which would prefer to see a lower Australian dollar.

Finally, as long as interest rates rise on a measured basis and balance sheet normalisation by central banks is gradual, equity markets should be able to keep moving higher. This is supported by corporate earnings that have not only been strong but also coordinated around the world.

The current economic environment is relatively benign, and markets are relatively calm at the moment, but the risk is that if there’s an unexpected shock, financial markets could see prolonged periods of volatility.

James Malliaros
Senior Financial Planner
SMSF Specialist Advisor™
Authorised Representative No. 291633

If you have any questions or comments, please email me at james@gfmwealth.com.au

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