Michael Hasenstab has called investors expecting a smooth unwinding of the Fed’s balance sheet ‘foolhardy’ and is bracing himself for a swift and significant jump in yields.
In a research paper titled ‘The long unwinding road’, Hasenstab, who is CIO of the Templeton Global Macro Group, said plans to shrink the central bank’s balance sheet may be too late.
‘The multi-year massive expansion of the Fed’s balance sheet has had a recognised powerful effect on asset markets—lowering yields and flattening the yield curve. Yet investors now seem to expect that the reverse process will have little impact, if any.
‘We disagree. We believe three factors have the potential to push bond yields higher; any single one could be sufficient to push yields well beyond current market expectations, and we see very little chance that none of them will materialise.’
Calling them ‘emergency measures in non-emergency times’, Hasenstab said there are three clear reasons as to why bond investors will bear the brunt of a change in ultra-accommodative policies.
#1 New buyers, please
As treasury buying decreases, Hasenstab said someone has to step in to replace the Federal Reserve in that capacity, but there are few willing candidates.
‘Our analysis shows that the burden will fall disproportionately on domestic, price-sensitive buyers like banks, mutual funds, pension funds and corporations. For these buyers to increase their demand, UST prices must fall and yields rise.’
#2 Bank reserves backlog
With the Fed no longer buying, it means bank reserves of treasuries will essentially stockpile, Hasenstab said. This will improve confidence and lending ability, which could see knock-on impacts for the wider market.
‘A well-entrenched and strengthening economic recovery will give banks a growing incentive to increase credit supply – all the more so as financial regulations will likely be eased over the coming year.
‘With stronger global growth and bolstered confidence, credit demand will also likely rise. This underscores the risk of a faster-than-expected acceleration in credit, which could further stimulate growth and raise inflation.’
#3 Inflationary fears
‘Wage and price pressures are unlikely to remain muted as the US economy, having reabsorbed all economic slack, keeps growing above potential—and the global economy with it,’ Hasenstab said.
However, he is unconvinced that the price Phillips curves have permanently flattened. ‘Moreover, both wage and price trends have a strong global component, and inflationary trends in the global economy are now likely to get stronger.
‘To assume that none of these three factors will come into play would be, we believe, foolhardy. As the Fed unwinds its balance sheet, we should ask not whether yields will rise, but how much faster and higher than market expectations.’