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David Brown

The United States Federal Reserve is just months away from one of its toughest-ever tests - the switch to quantitative tightening from quantitative easing.
The transition of monetary policy from munificence to meanness poses substantial risks for US businesses, international investors and the global economy.
The problem is how to deconstruct a US$4.3 trillion mountain of asset purchases built up over the past six years at the same time as guiding interest rates from zero to more normal levels associated with the economy moving back towards sustainable growth and full employment - and all without causing a systemic shock.
It is a job that calls for policy gradualism, smooth communication and expert expectation management.
Bear in mind that with the Fed already running down its bond purchases, the cash that has kept global markets floating for six years is close to being exhausted.
Monthly bond purchases are down to US$35 billion from last year's peak of US$85 billion. At the current rate, the programme will have hit full stop within three to four months.
And that heralds the start of excess money being drained from the system.
The Fed's economic gradualism so far seems to be working.
A dovish-sounding Janet Yellen has helped. She has largely convinced investors that it will be a long time before she would consider selling off any of the Fed's US$4.3 trillion bond portfolio.
That has helped markets take a serious sequential downward revision to gross domestic product growth for the first quarter in their stride and reinforced the belief that the economic outlook remains bright, even with the "taper" in full operation.
At the same time, volatility in asset prices has collapsed, US stocks have notched up record highs and the US treasury market remains in the thrall of a 33-year bull cycle.
At issue is whether markets are taking one last sip from the policy punch bowl before its heady mix is totally drained, the bowl taken away and the hangover sets in.
US treasury bonds will be critically exposed in the asset allocation stakes relative to equities as economic fundamentals in the country firm and the Fed is forced to tighten.
That inevitably means higher market interest rates, regardless of where the federal funds rate sits.
The 30-year treasury yield hit a quantitative-easing-induced cyclical low of 2.45 per cent in 2012. Its pre-crisis peak in 2007 was 5.4 per cent.
As soon as the Fed starts to take a U-turn, borrowing costs are likely to jump - and fast.
Stronger growth, upward inflation pressures, rising interest rates and an increasing supply of US government paper are all going to come at once and that means investors in the US treasury debt market will get hit hard.
The Fed already alludes to the probability of a slightly faster pace of interest rate rises next year.
Once the lid is off higher rates, market expectations will be looking for a potentially quick normalisation of the federal funds rate back towards a neutral level between 4 and 5 per cent in the next few years.
With most of the US bond market's fundamental and technical supports eroding fast, the gravitational pullback to pre-crisis yield levels above 5 per cent will intensify.
Within this context, recent market surveys projecting long-term US treasury yields rising 100 basis points over the next 12 months could be relatively tame.
Running down a quadrupled balance sheet at the same time as it tenaciously holds on to interest rates at zero is a challenge that should not be underestimated.
David Brown is the chief executive of New View Economics


Fed faces tall order to switch policy with economic gradualism

Fed faces tall order to switch policy stance with gradualism

Business

Banking & Finance

US central bank needs to adopt a tightening approach after six years of quantitative easing without upsetting the global economic system


The United States Federal Reserve is just months away from one of its toughest-ever tests - the switch to quantitative tightening from quantitative easing.


Fed faces tall order to switch policy with economic gradualism

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}US central bank needs to adopt a tightening approach after six years of quantitative easing without upsetting the global economic system

US central bank needs to adopt a tightening approach after six years of quantitative easing without upsetting the global economic system