The great Fed unwind could cause market turmoil

A recent working paper published by the International Monetary Fund looks at the impact of unconventional monetary policy on an open economy, taking Canada’s case as an example.

The paper’s main finding is that unconventional monetary policy by the Canadian central bank has had expansionary effects on the Canadian economy.

Output, for which the paper’s authors used industrial production as a proxy, was boosted by 0.013% per month on average during the periods of unconventional monetary policy.

But the paper also shows that Canadian industrial output would have been around 0.127% lower per month, on average, without the unconventional monetary policies in the US.

It is no surprise that the Federal Reserve’s monetary policy has such big influence on Canada. The IMF paper also states that there is evidence that globally, monetary policy spillovers tend to be one-directional, spilling from the US to abroad. Evidence of spillbacks is limited, even from other large, open economies.

This is because the dollar is the world’s uncontested reserve currency, but also because of the way the Fed’s balance sheet has swollen since the 2007-2009 financial crisis. A look at the Fed’s balance sheet explains why.

It is currently at $4.45 trillion, and Jerome Powell, who is set to replace Janet Yellen as chair, wants to see it go down to $2.5-$3 trillion in about three years, according to his testimony in the U.S. congress.

All this cash thrown into the markets since the financial crisis could not have been without consequence. Investors are still merrily buying any asset that looks vaguely promising — witness the meteoric rise of bitcoin, which is being snapped up by all and sundry these days, although few people understand what the cryptocurrency does and how it works.

Powell’s ambition for shrinking the balance sheet may seem modest. Cutting some $1.5 trillion in around three years may not look like a lot. But think about it: it still means around $500 billion a year that will be pulled from the markets.

Some people believe US stock market movements have more to do with the world than with the Fed.

But with the S&P 500 representing about 30% of total global stock market capitalization, in fact global markets are much more likely to move the way US stocks go.

The rising tide of Fed asset purchases has lifted all boats. Let’s see how many of them will be still afloat once that tide goes out.