Q3 Outlook with Paul Chan

Paul Chan, Head of Multi-Asset & Hong Kong Pensions at Invesco, explains how pension investors should position themselves in light of the shrinking Fed balance sheet, and why he prefers US equities to European equities.

Jul 19, 2017 | Paul Chan

The US Federal Reserve has already started raising interest rates from financial crisis-era lows. Now, it is preparing to embark on what could be the more perilous part – unloading the US$4.5 trillion of bonds it holds on its balance sheet.

Q: Why are investors concerned about the unwinding of the US balance sheet?
The overall recovery in the US is on track, with the unemployment rate coming in at 4.3% in May 2017, the lowest since May 2001. In response to this, the Federal Reserve (Fed) concluded that the economy no longer needs help and therefore has scheduled three increases in interest rates in 2017. In addition, the Fed is actively considering a profound change in US monetary policy – shrinking its portfolio of Treasuries and mortgage-backed securities. Many investors are concerned that the shrinkage of the balance sheet may impair global liquidity. But I don’t think so.

The Fed’s balance sheet in total now runs US$4.5 trillion, of which US$3.7 trillion came from buying Treasuries and mortgage-backed securities in response to the financial crisis in 2007. This quantitative easing was aimed at injecting money into the economy and encouraging global bank lending to revitalize the anemic economic growth. The Fed stopped buying large quantities of assets in October 2014. Since then, it has kept the size of its balance sheet constant, buying just enough to replace maturity securities.

I believe that the shrinkage is unlikely to have significant impact on global markets. This is because global liquidity is still well supported by other G5 central banks – a total of more than US$ 18 trillion, of which the US represents about 23%. The US balance sheet shrinkage itself will not undermine global liquidity, as other central banks are unlikely to retreat from their aggressive accommodative policies together.

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