Source: NY Fed, BLS, Bloomberg
What then for the impact on US treasuries? The communicated plan to reduce the Fed’s balance sheet is to decrease the reinvestment of principal by an extra $10bn each quarter through 2018 from $20bn to $50bn and then continue at this pace, however debate remains about how long this policy shall continue, or put another way, what is the target size of their balance sheet. Note the current size of the assets on the balance sheet is approximately $4.5tn dollars.
At the same time, as a result of the fiscal stimulus, the Federal deficit is expected to be $804bn in 2018 and $981bn in 2019, resulting in approximate net issuance if $1.17tn in each year. All of this is at a time when foreign demand for Treasuries is waning, particularly from the largest holders Japan and China.
Source: US Treasury, Bloomberg
Hence, what remains to be seen is whether the necessary demand to offset the large increase in supply is met by international investors, through outflows from other asset classes, or to what extent yields will rise.
Source: Robin Brooks (Chief Economist, IIF)
Governor Draghi once again demonstrated a masterclass in communication of monetary policy at this week’s ECB meeting in Riga. Despite announcing the plan to taper the Asset Purchase Programme in September and to fully wind it down by December, European equities and bonds rallied. His rhetoric was sufficiently cautious to calm investors who were concerned that the ECB could prematurely tighten policy, like they did in 2011, especially as indicators of core inflation remain well below target and economic data has been much softer in 2018, albeit falling from very elevated levels in the second half of 2017.
The key aspect of the statement was that rates will remain unchanged at least through the Summer of 2019, towards the end of Draghi’s tenure, and the extent which he stressed ‘significant monetary stimulus’ was still needed to bring inflation sustainably towards the 2% target. It seems that monetary policy divergence between the US and Europe, which can be seen through the difference between 2 year bond yields for the US and Germany, is to continue for a while yet.
In the face of policy tightening across the globe, the Bank of Japan kept monetary policy on hold at their meeting on 15th June, maintaining interest rates at -0.1%, the 10-year bond yield pegged to 0% and committing to asset purchases of ¥80tn a year. There remains an absence of price pressures in the region, which Governor Kuroda explained recently has been a result of falling durable goods prices, caused by the stronger currency and temporary weakness in accommodation prices, but also noted that Japan has a challenge in combating the deflationary mindset of households and companies, which have become entrenched due to 15 years of deflation.
Furthermore, future inflation forecasts were downgraded which we believe signals that moves towards tightening in the region will begin a long time in the future, and with an additional consumption tax hike planned for 2019, it may even be that further easing is required to stimulate demand.
The Bank of England meet on 21st June – we will discuss any noteworthy developments afterwards.