Central banks to desert Brexit Britain on path to normalisation

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The US Federal Reserve will lead its global peers on balance sheet reduction at its meeting this week, in a post-global financial crisis milestone that will leave behind a Bank of England coming to terms with Brexit.

The Fed’s open market committee (FOMC) plans to reduce its balance sheet, consisting $2.5trn of Treasuries and $2trn in mortgage-backed securities, have been well signalled in order to minimise the impact on markets. Monthly reserves will drop by $10bn, the FOMC noted in its June meeting.

At a presentation in London this week, Lyxor senior cross-asset strategist Lionel Melin, who was visiting from Paris, said global peers will follow in the Fed’s footsteps.

“This will be the starting point,” Melin says. “They led the way in introducing QE, we believe they will lead the way in normalising monetary policy globally.

“We believe the ECB will come next, although with a lag, and the BoJ will come third, but keeping a distance.”

Melin avoided dwelling on forecasts for the Bank of England, describing it as a “special case” due to Brexit that would not follow in the footsteps of the other three. “Here we are not talking about removing accommodation that was infused due to the crisis.”

Although Melin noted the Bank of England had indicated it was prepared to pull some support at its last policy meeting, the central bank still needed to tackle “risks or dynamics linked to Brexit negotiations”.

While US Federal Reserve chair Janet Yellen has compared the process to “watching paint dry”, Aberdeen Standard Investments fixed income managerJames Athey says the confirmation of balance sheet normalisation at Wednesday’s meeting would launch a fraught process unchartered in the post-global financial crisis era.

“If the signals are right then this week should mark the point when the Fed finally begins the long-overdue process of unwinding its bloated balance sheet,” Athey says. “That would make it a milestone in the post-crisis monetary experiment.”

“Inching us out of this parallel universe of endless liquidity is going to be a fraught process, Athey warns. “No one’s done it before so no one can credibly claim to know what will happen. We are very early on in the process but, so far, financial markets have largely remained unmoved and unencumbered by the prospect of falling, as opposed to endless, liquidity.”

Two incredients are needed for market to sustain a withdrawal, Melin says, noting the high correlation between liquidity injections and the performance of equity markets since the financial crisis.

“The question with the withdrawal of central banks is whether markets globally are able to lead by themselves and not suffer. The key ingredients for that to evolve smoothly are growth and inflation,” Melin says.

“We believe central banks will normalise slowly enough not to endanger the progress they’ve made.”

Athey says there is market complacency regarding a December rate hike from the US Fed, but the “fly in the ointment” is the debt ceiling talks.

“We all know how destabilising previous debt ceiling episodes have been and it’s certainly feasible to think the Fed will want to avoid risking any more volatility if the discussions are going down to the wire.”

US interest rates’ current range is 1 per cent to 1.25 per cent.