Bobby Zheng, CFA Investment Strategy Analyst Luis Alvarado Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Fed Tightening: How Global Markets May React August 8, 2017 Key Takeaways» The Federal Reserve (Fed) is not the only central bank with a historically high level of balance sheet assets.» Domestically, we believe that a reduction to the Fed s balance sheet will impact the mortgage-backed securities (MBS) market more than the Treasury securities market, given the size, volume, and amount of reductions in both markets. What It May Mean for Investors» We do not expect the initiation of the Fed s balance sheet reduction program to have a material impact on the bond market as a whole; however, we believe that investors should remain alert. As mentioned in our Investment Strategy report 1 last week, the Fed likely will initiate its plans to reduce the assets held on its balance sheet later this year (possibly as early as September). This normalization of monetary policy has raised concerns among market participants, as it likely means a reduction in asset purchases and further increases in the federal funds target interest rate. In this report, we will compare the Fed s approach to monetary policy with that of central banks in other parts of the world, outlining some of the effects central bank actions may have on financial markets. We will also provide some guidance for investors on how to manage their portfolios as these events unfold. The U.S. Federal Reserve s Portfolio within a Historical and Global Context When central banks purchase securities in the open market, they typically buy from commercial banks and provide cash in exchange. The central bankers hope that the commercial banks will lend the money into the economy, promoting economic activity. In such an environment, bond yields can fall taking mortgage rates lower as well and equity prices can rise, as business borrowing costs decline. For perspective, according to the New York Fed, as of July 17, 2017, the total value of assets on the Fed s balance sheet stood at $4.2 trillion dollars. This translates to 22.6 percent of U.S. gross domestic product (GDP), more than four times its level at the beginning of the financial crisis in 2007. Since the Fed s establishment in 1914, the highest level of balance sheet holdings relative to GDP had been 10.6 percent. This prior high was reached in 1945 due, in part, to special financing needs during World War II. 1 A Shrinking Fed Balance Sheet is No Cause for Alarm, Wells Fargo Investment Institute, July 31, 2017 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 5
Today, the Fed is not the only central bank with a historically high level of balance sheet assets. Several other major central banks, including the Bank of Japan (BoJ) and the European Central Bank (ECB), also have increased their total central bank assets since the great recession (Chart 1). By contrast, China has provided its stimulus in a different way. The People s Bank of China (PBoC) holds large U.S.-dollar reserves and has sold off a significant portion to provide dollars to companies that need to make payments on dollar-denominated borrowing. As the PBoC sold dollars, it provided important liquidity to the economy, but actually reduced the size of its balance sheet in the process. Chart 1. Global Central Bank Balance Sheet/GDP Ratios Central Bank Assets as a percentage of GDP 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% People's Bank of China (PBoC) Bank of Japan (BoJ) European Central Bank (ECB) U.S. Federal Reserve (Fed) 10.0% 0.0% 02' 03' 04' 05' 06' 07' 08' 09' 10' 11' 12' 13' 14' 15' 16' Source: Wells Fargo Investment Institute (WFII), Bloomberg, as of 3/31/2017 Tightening Monetary Policy Effects Of the 10 largest economies (including the Eurozone as a whole), the U.S. likely will be the only country to experience multiple rate hikes in 2017. Therefore, while most other central banks continue with additional stimulus packages, the Fed is pursuing a tightening monetary policy through a reduction of its balance sheet and an increase in its base interest rate (the federal funds target rate). In our opinion, these two actions might halt the U.S. dollar s decline in relation to other major currencies (everything else remaining equal). The attractive yield spreads between U.S. Treasury securities and many other sovereign bonds are likely to support demand for U.S.-government fixed income securities. On the other hand, we view the relatively lower-yielding fixed income securities offered by the Eurozone and Japan as unattractive at this time. Domestically, we believe that a reduction to the Fed s balance sheet will impact the MBS market more than the Treasury securities market, given the size, volume, and amount of reductions in both markets. 2017 Wells Fargo Investment Institute. All rights reserved. Page 2 of 5
As shown in Chart 2, the annual Treasury reduction would only amount to a small fraction of the annual gross Treasury new issuance. However, the projected MBS reduction could amount to 7.4 percent of the entire MBS market new issuance, which would need to be absorbed by market participants other than the Fed. Additionally, higher federal fund rates and a faster-than-expected reduction in MBS purchases by the Fed may have a transitory impact on the credit market and affect liquidity in the short term. Mortgage rates, in particular, could rise as a result, potentially negatively impacting home affordability and the overall health of the housing market. Chart 2. Fed s Purchases Impact on Treasuries and MBS $10,000 $9,000 Trialling 12M Total Gross New Treasury Issuance Projected Treasury Annual Reduction 0.8% Billions $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 99.2% Trialling 12M Total MBS New Issuance Projected MBS Annual Reduction 7.4% $0 Total Gross New Treasury Issuance Total MBS New Issuance Treasury Average Daily Trading Volume Trailling12M Projected MBS Average Treasury Daily Trading Annual Runoff Volume Projected MBS Annual Runoff 92.6% Source: Wells Fargo Investment Institute (WFII), Federal Reserve of New York, Securities Industry and Financial Markets Association (SIFMA), As of 7/17/2017 How Should Investors Prepare for a Tightening Fed? Although historically the U.S. has experienced three incidences in which the Fed trimmed its balance sheet and increased its target rate at the same time, we believe investors should remain alert as the scale and magnitude of this event is unprecedented. Although MBS can provide alternative income opportunities in the current low-creditspread environment, we suggest caution as the Fed begins to slow down its reinvestments in the MBS market. Currently, we have a neutral view for residential MBS, and an unfavorable view for commercial MBS. We do not expect the initiation of the Fed s balance sheet reduction program to have a material impact on the bond market as a whole. However, liquidity on a global scale is important for fixed-income market stability. Thus, if other major central banks decide to follow in the Fed s footsteps sooner or more aggressively than currently expected, such a move could shrink market liquidity and cause a short-term surge in volatility. Holding a globally diversified portfolio could help to cushion a potential downturn resulting from central bank tightening. 2017 Wells Fargo Investment Institute. All rights reserved. Page 3 of 5
Economic Calendar Date Report Estimate Previous 8/7/2017 Mortgage Delinquencies -- 4.71% 8/7/2017 MBA Mortgage Foreclosures -- 1.39% 8/8/2017 NFIB Small Business Optimism 103.5 103.6 8/8/2017 JOLTS Job Openings 5657 5666 8/9/2017 MBA Mortgage Applications -- -2.80% 8/9/2017 Nonfarm Productivity 0.80% 0.00% 8/9/2017 Unit Labor Costs 1.10% 2.20% 8/9/2017 Wholesale Trade Sales MoM -- -0.50% 8/9/2017 Wholesale Inventories MoM 0.60% 0.60% 8/10/2017 Initial Jobless Claims 240k 240k 8/10/2017 Continuing Claims 1960k 1968k 8/10/2017 PPI Final Demand MoM 0.10% 0.10% 8/10/2017 PPI Ex Food and Energy MoM 0.20% 0.10% 8/10/2017 PPI Ex Food, Energy, Trade MoM 0.20% 0.20% 8/10/2017 PPI Final Demand YoY 2.20% 2.00% 8/10/2017 PPI Ex Food and Energy YoY 2.10% 1.90% 8/10/2017 PPI Ex Food, Energy, Trade YoY -- 2.00% 8/10/2017 Bloomberg Consumer Comfort -- 49.6 8/10/2017 Monthly Budget Statement -$55.5b -$90.2b 8/11/2017 CPI MoM 0.20% 0.00% 8/11/2017 CPI Ex Food and Energy MoM 0.20% 0.10% 8/11/2017 CPI YoY 1.80% 1.60% 8/11/2017 CPI Ex Food and Energy YoY 1.70% 1.70% 8/11/2017 CPI Core Index SA -- 251.627 8/11/2017 CPI Index NSA 244.932 244.955 8/11/2017 Real Avg Weekly Earnings YoY -- 1.10% 8/11/2017 Real Avg Hourly Earning YoY -- 0.80% Source: Bloomberg as of 8/4/17 2017 Wells Fargo Investment Institute. All rights reserved. Page 4 of 5
Risk Considerations Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Mortgage-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market s perception of issuer creditworthiness; changes in prepayments may significantly affect yield, average life and expected maturity of the portfolio. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0817-01100 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 5