“This us tightening cycle is different”

Market participants are underestimating how high interest rates will go, says Russell Silberston of Ninety One. It also means, she said, that bond yields will rise much more sharply and bond prices will fall correspondingly low.

Fourteen years ago, the financial crisis swept the global economy and led to interest rate cuts around the globe. As recently as December 2015, the Fed raised the target rate by 0.25% to 0.5%. However, it took another year for the cycle of rate hikes to begin in earnest with an increase of another 25 basis points in December 2016.

A series of quarterly hikes of 25 basis points followed, pushing the Fed Funds Rate up to 2.5% by December 2018. However, in just seven months, the Fed has been forced to partially reverse these tightenings. The key interest rate was then adjusted to 1.75% in the second half of 2019, as financial markets were very volatile despite the good performance of the economy.

"Now that the Fed is once again at the beginning of a tightening cycle, history is repeating itself in financial markets", Says market strategist Russell Silberston of Ninety One. The Fed is only expected to be able to raise rates to around 1.75%, he says. This, he said, is a far cry from the economically neutral level of interest rates. "The Federal Reserve's desire to shrink its balance sheet stands in the way of further rate hikes", according to Silberston.

If one looks at the very high inflation, the confidence in the financial markets with regard to the development of interest rates is astonishing. The answer for the relative serenity, he said, is rooted in the Fed's balance sheet and, in particular, the amount of excess reserves that commercial banks have placed there.

Quantitative streamlining according to plan

When a central bank eases monetary policy (quantitative easing), it creates reserves for itself and uses them to buy government bonds and other assets. These sit as assets on their balance sheet. "The money it created to buy these assets ends up in the banking system, which in turn flows back to the central bank as excess reserves", Explains the market strategist. Like any bank deposit, these represent a liability for the central bank. So, in accounting terms, both the assets and liabilities of the central bank have increased.

Quantitative tightening (quantitative tapering) reverses the process: The central bank either sells a bond or lets it mature, reducing the asset side of the balance sheet. As a result, the central bank's liabilities are also shrinking as commercial banks' excess reserves decline at the same rate.

When the Federal Reserve last began tapering, they made two estimates regarding liabilities: First, how many bills and coins would be needed, and second, how many reserves commercial banks would need. The former is fairly easy to calculate: "Take the current level and assume that it grows with nominal GDP", Silberston further explains.

The second question is more difficult to answer. That's why the Fed periodically surveys all major banks about future reserve requirements. From this, the Federal Open Market Committee (FOMC) determines a rough target for the optimal size of the balance sheet.

Compass misaligned

As excess reserves shrank as a result of tapering, it quickly became clear that banks needed far more reserves than they were reporting. Whatever the reason – there are various theories on this – the Fed's compass was set incorrectly. "The Federal Reserve has overdone it with tightening, withdrawing far more liquidity than the banking sector could spare. We believe this was the reason for the aborted tightening cycle in 2016/2018", says Silberston.

This time be different! To prevent history from repeating itself, the Federal Reserve has introduced new tools to manage overnight interest rates for the current cycle. So, at least in theory, it should be able to shorten the balance sheet without causing the cash shortages of recent cycles. "If this is true, the market underestimates how high interest rates will rise. This also means that bond yields will rise much more and bond prices will fall correspondingly lower", Silberston concludes.