With huge media attention on the annual meeting of central bankers at Jackson Hole, Wyoming, Iggo says the Fed is on track to withdraw a lot of the post crisis stimulus in the expectation of rising inflation with continued falling unemployment.
Iggo (pictured) says: “It’s hard to argue that the Fed creating liquidity did not have a positive effect on financial and real asset prices. Therefore it is just as hard to argue that the Fed reducing liquidity won’t have the opposite effect.
“Make no mistake, the Fed not fully re-investing the proceeds from maturing bonds does lead to a reduction in liquidity in the economy and this will show up in lower excess reserve balances at the Fed. However, it is what it does to portfolio holdings that will determine returns in bond and equity markets, almost irrespective of what the economy does.”
Iggo says the relative holdings of treasuries in the private sector might not change if the US was running a balanced budget and therefore did not need to issue any new bonds as old ones matured. But he says that is clearly not the case and is not going to be the case given the structural weaknesses in the US Federal Budget.
“The only conclusion is that Treasury yields will rise and credit spreads will widen. The alternative scenario is for a massive increase in foreign buying of treasuries to offset the Fed’s balance sheet reduction.”
Iggo says that the US Treasury still needs to fund a budget deficit of roughly $5bn per month so it will keep issuing Treasury bills, notes and bonds.
But if the Fed is not buying the bonds, then the private sector has to, and for this to happen, the prospective return on treasuries needs to be better than the return on other assets.
This should mean higher yields and a shift in preference amongst investors towards government bonds and away from risk assets. “The crowding out will mean higher credit spreads and this is likely to be associated with weaker equity prices.”
He adds that given the Fed has trumpeted the positive impact of the portfolio balance effect, it will not be under any illusions about the reverse impact.
“The run-down in the balance sheet will be done very slowly,” Iggo asserts.
“If there is any sign of a slowing economy or further disappointment on the inflation front, the Fed can just delay normalisation even further. I am not sure that equities and credit can keep on performing under a scenario of slowing growth. That would be a big signal for an even weaker dollar.”