One mega-bank believes that policy normalization performed by the Fed should now slow
“The Fed has probably done enough on normalization for now and should take a well-earned break! The fact that they won’t yet, informs our strategy: stick with the risk off.” — DB analyst Dominic Konstam.
The US Federal Reserve’s efforts to normalize monetary policy have gone far enough, and the central bank should now take a holiday as markets cool down, that’s the view of Deutsche Bank’s global markets research analyst Dominic Konstam.
In a report published over the weekend, Konstam notes that, according to the Fed’s forecasts, the bank is set to hike rates once again during December of this year, after starting its balance sheet reduction efforts in October. Following these actions over the next few months, in 2018 the Fed is set to increase rates further on three occasions.
The Fed Should Slow Policy normalization
Konstam argues that these policy normalization actions risk setting off a chain reaction in markets as they come at a dangerous time. As well as the Fed, central banks in Europe and Japan are starting to wind down their own QE programs. The ECB is poised to announce the next adjustment to its ongoing QE purchase program in September. DB economists expect the taper to be from €60 billion down to €40 billion per month starting in January 2018.
Meanwhile, BoJ doesn’t have policy normalization nor a formal purchase target but instead the interest target. "However de facto this has already implied a significant reduction in purchases. Purchases of long term bonds has slowed from a quarterly average peak of over 20 trillion in 2016 to just over 12 trillion in the three months to July, 2017."
Against the uncertain global backdrop, the Fed is also facing issued at home. Konstam highlights the cash: deposit ratio for US banks, which currently sits around 20% and has been declining since 2014 -- a good sign. Recently, however, the ratio has remained flat and, if anything, "shows signs of rising again." A shrinking balance sheet will push the yield curve higher and reduce bank lending, possibly having an adverse impact on economic growth.
"There is clearly a tension in the market between investors that, in our view, are rightly concerned about what they may view as premature removal of monetary accommodation and those that see the monetary accommodation as part of the problem via for example excessively, flat curves that may discourage lending. The logic of this is extended to the notion that bonds may be in a bubble as a result -- as soon as QE is unwound the bubble will collapse."
The central bank normalization will have a sizable impact on debt markets around the world over the next 12 months. DB calculates that assuming the Fed starts to taper reinvestments in October and the ECB cuts its pace of buying to €40 billion a month in January, and decreases by €10 billion a month, down to a steady €10 billion a month in the second half of next year, "the forward looking QE flow would slip to about 25% of net issuance by the middle of next year," down from a staggering 200% of net issuance in the first half of 2016.
With such a significant drop in asset buying and uncertainty building, DB recommends investors take a risk off stance.