Monetary tightening is slowly broadening out from the US across to a range of other developed economies. This represents a significant change from the ever-looser policy environment of the past decade.
There are two elements to tighter policy. First, central bank balance sheets will peak within a year. Second, interest rates are rising.
This is positive from the perspective that it reflects a normalisation of the world economy after the prolonged disruption of the Global Financial Crisis, but negative from the perspective of creating a more challenging investment environment. Our tactical asset allocation stance remains cautious, with an underweight position in equities.
The immediate focus is on the US Federal Reserve which is set to announce plans to reduce the size of its balance sheet. This will be a gradual process, starting at $10bn per month and rising to $50bn by the end of 2018. At this pace it will take around four years until the size of the Fed balance sheet is back to normal. The process is set to run on autopilot, without sensitivity to short-term fluctuations of the economic cycle, which might be useful considering the uncertainties surrounding the future make-up of the Fed policy board.
The Fed has signalled its intentions on the balance sheet well in advance, so market attention could be focused on the "dot chart" at the next policy meeting. That will show whether they are backing away from the planned four rate hikes by end 2018 - the market only expects a single hike.
We still think four Fed rate hikes is a realistic expection which is a reason not to become too pessimistic on the outlook for USD. However, the US has lost its unique position as the only country prepared to tighten policy, which had boosted USD in 2015-2016.
Even though the European Central Bank is set to cut back on asset puchases in 2018, it will probably not stop althogether until 3Q 2018. At that time the balance sheet of the G3 central banks will start to shrink, as Fed cuts will be larger than Bank of Japan buying (which has already faded).
G3 central bank balance sheets near to a peak
The ECB could hike interest rates by the end of 2018. Japan is much further behind in the process, whic reflects the struggle to pull inflation away from zero. This is a reason to remain moderately negative on JPY.
The focus is not just on the balance sheets of G3, but also on interest rate hikes in other developed economies. Canada has already put through two rate hikes since July, while Sweden and Australia will probably move in around six months. Even the UK is hinting at an imminent rate hike, despite Brexit uncertainties.
The pace of tightening is likely to remain very gradual. Economic growth is increasingly robust, but inflation is still sluggish (apart from the UK). This means that central banks want to show prudence, and slowly guide policy towards neutral settings, but they do not need to act with any urgency.
Even though the speed will be slow, the direction is clear. After nearly a decade of progessively looser monetary policy, we are heading for a multi-year period of tightening and this is likely to be a very different environment for investing, characterised by potentially higher financial market volatility.Disclaimer applicable to recommendation
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