For nearly a decade, financial markets have surfed a wave of low-cost money in the United States, courtesy of the US Federal Reserve’s massive quantitative easing, or QE, programs that were launched after the global financial crisis of 2007–2009. The expansion of the Fed’s balance sheet from around $900 billion in 2008 to nearly $4.5 trillion today has arguably been the most dominant force shaping global financial markets.
QE has driven down yields and pushed up asset prices, steering many investors toward riskier assets while keeping the costs of capital artificially suppressed. This has distorted valuations in bonds and in equities.
In short, the era of QE has created a seemingly complacent market that views persistently low yields as a permanent condition. However, these conditions are neither normal nor permanent, in our assessment, and we expect the reversal of QE by the Fed to meaningfully impact financial markets in 2018 and beyond.
Rising US Treasury Yields Present Multiple Risks
A number of factors are poised to pressure US treasury yields higher, in our view, including the aforementioned reversal of QE as the Fed unwinds its balance sheet, but also the exceptional strength in US labor markets, rising wage and inflation pressures, ongoing resiliency in the US economy, and a structural shift toward deregulation by both the Trump administration and a Jerome Powell Fed. The Fed is projected to unwind $1.5 trillion from its balance sheet over the next three years. At the same time, major foreign buyers of US treasuries from prior years have notably stopped acquiring US treasuries over the last few years.
China has reduced its foreign reserves by around $1 trillion, while oil exporting nations like Saudi Arabia have similarly become net borrowers instead of lenders, no longer buying massive levels of US treasuries. Now the Fed will also be departing that market, further driving down the supply of US treasury buyers.
At the same time, overall US treasury borrowing remains on an upward trend. This leaves price-sensitive domestic US investors to predominantly fill the void. We expect those dynamics to put upward pressure on US treasury yields.
Investors who are not prepared for the shift from the recovery era of monetary accommodation to the expansionary post-QE era may be exposed to significant risks, in our view. Markets could see sharp corrections to US treasury yields in upcoming quarters, similar to the magnitude and speed of adjustments that occurred during the fourth quarter of 2016. We think it is critical not only to defend against current US treasury risks but to structure portfolios to potentially benefit as rates rise.
The challenge for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets may not hold true in this new cycle of UST declines. It’s quite possible to see risk assets also decline as the "risk-free" rate (yield on US treasuries) ratchets higher.
Markets have become accustomed to exceptionally low discount rates — a shift higher would materially impact how those valuations are calculated. Additionally, we’ve seen a sense of complacency develop across the asset classes as US treasury returns and risk asset returns have often had positive correlations, along with positive performance.
However, the positive outcomes achieved under the benefit of extraordinary monetary accommodation can mask the actual underlying risks in those asset categories. As monetary accommodation unwinds, those positive correlations could continue but with the opposite effect — simultaneous declines across bonds, equities and global risk assets as we exit an unprecedented era of financial market distortions.
These are the types of correlations and risks we are aiming to avoid in 2018.
Indonesia Offers Idiosyncratic Value
The impact of Fed policy tightening on emerging markets should vary from country to country in the upcoming year. There are still attractive valuations in specific countries, but not all emerging markets will fare well as rates rise, in our assessment.
It’s important to identify countries with idiosyncratic value that may be less correlated to broad-based beta (market) risks. Countries that are more domestically driven and less reliant on global trade often have those idiosyncratic qualities along with inherent resiliencies to global shocks.
A select few have already demonstrated that resilience in recent years, notably Indonesia. For others, economic risks are related to the reforms underway within their country, rather than what happens externally, such as in Brazil or Argentina.
Higher rate differentials are also crucial in a rising-rate environment. Brazil and Mexico have short-term yields around 7 percent, India and Indonesia around 6 percent, and Argentina around 25 percent (as of November 2017). If US rates rise by 100 or 200 basis points, these countries have more cushion to absorb rate pressures.
By contrast, emerging markets with macro imbalances or low rate environments should be impacted harder by rising rates. Countries like Turkey or Venezuela remain fundamentally vulnerable to a rate shock, in our view. Another group of potentially vulnerable countries are those with lower rates, such as South Korea or Singapore, which despite strong macro fundamentals could also be vulnerable to currency depreciation as the yield differential with the US flips.
Thus we think the key to emerging-market allocations in 2018 will be to avoid the broad beta risks and find those idiosyncratic sources of alpha (performance above the market return) that can withstand rising rates.
In the major developed economies, we continue to see unattractive bond markets, particularly the low to negative yields in the eurozone and Japan. As rates rise in the US, we expect the widening rate differentials with the eurozone and Japan to weaken the euro and yen against the US dollar.
We Expect Inflation and US Treasury Yields to Rise in 2018
As we look ahead in 2018, we expect the reversal of QE, rate hikes and rising inflation pressures in the US to be among the most impactful factors for global financial markets in the upcoming year. When the first rounds of QE were initially deployed by the Fed nearly a decade ago, many skeptics argued that pumping money into the financial system would cause high inflation. But inflation never accelerated, in part because banks and financial companies stockpiled cash while credit activity remained constrained by post-GFC regulations, such as the Dodd-Frank Act.
However, the factors that previously limited inflation and money creation over the last decade are also now approaching their end. Deregulation efforts through executive action are already underway, while credit activity has been accelerating. In short, the credit expansion and money velocity — which measures the rate at which money is circulated through an economy — that did not materialize over the last decade is just beginning to take shape.
This potential acceleration in money velocity combined with existing inflation pressures in the US economy and labor markets leads us to expect higher inflation and higher US treasury yields in the upcoming year. We think investors need to consider preparing for these risks.
Michael Hasenstab is the executive vice president, portfolio manager and chief investment officer at Templeton Global Macro, a unit of Franklin Templeton Investments