With the annual meeting of central bankers in Jackson Hole, Wyoming, global financial markets confronted the first in a series of potential trigger points that stand to materially impact a range of asset classes over the coming year. We believe there is significant risk that the global economy could face an unintentionally coordinated unwinding of major central bank balance sheets, and that the market is largely underestimating the risk of any adverse outcomes triggered by this scenario.
The Federal Reserve (Fed) has explicitly telegraphed its intention to start reducing the level of assets it holds later this year. It is likely to be joined at some point by the Bank of England, the National Bank of Switzerland and Sweden’s Riksbank. We even expect that the European Central Bank (ECB) will at least begin to taper the level of its asset purchases. This comes on the heels of perhaps the greatest period of monetary stimulus ever. The liquidity produced by quantitative easing (QE) over the past several years created numerous distortions in financial markets, including suppressed volatility. We have long anticipated there would be unintended consequences to the role central banks assumed as the marginal buyer of government debt, mortgages and other financial assets. We think it is foolish to believe that the removal of this “buyer of last resort” will be as seamless as the market presently anticipates.
Right now, investor complacency remains our greatest concern. Any unexpected policy announcement could send shockwaves through markets. For this reason, we believe that it’s of paramount importance that the Fed is extremely careful laying out its plan for the coming year, starting in Jackson Hole, and again at its September Federal Open Market Committee (FOMC) meeting. The need for transparent communication also applies to Mario Draghi and the ECB, which is scheduled to update its monetary policy path in October.
During the era of QE, the market has operated under the assumption that the so-called Fed put (ie, the central bank supporting financial asset prices) is in place. That is going away. The carry trade of borrowing at a low interest rate and investing in higher yielding assets, as well as the high valuations of some risk assets will be subject to greater vulnerability, as both have been underpinned by the market’s belief in the Fed put. We are not predicting that there will be a pullback, but rather cautioning that the Fed must be quite careful how it crafts its message in preparing markets for its diminished role in determining asset prices. From our viewpoint, the market must heed these messages and give greater consideration to the possibility that the removal of central bank largesse will not be as tranquil as expected.