As US economy improves, monetary policy normalisation becomes a risk

Economic reports last week indicate that the United States economy appears to be accelerating after the weak spell at the start of the year.

The Conference Board's index of US leading indicators rose 0.4 percent in April, its fourth consecutive monthly increase.

The housing market showed signs of rebounding, with existing home sales rising 1.3 percent in April and new home sales jumping 6.4 percent.

The flash reading of Markit's US manufacturing purchasing managers index for May was 56.2, higher than the 55.4 reading in April.

The Chicago Federal Reserve's national activity index did fall to -0.32 in April from +0.34 in March. Nevertheless, the index's three-month moving average rose to +0.19 in April from +0.04 in March.

Even as the US economy picks up pace though, risks for financial markets may be increasing as monetary policy looks likely to return to normal from the current ultra-easy and unconventional one.

At a speech last week, San Francisco Federal Reserve President John Williams said that, after five years of extraordinary monetary policy, the US economy appears to be making a sustained recovery.

This in turn means that monetary policy is “on the road back to normal”.

However, Williams also warned that monetary tightening after years of “highly accommodative” monetary policy “may exacerbate potential risks to financial stability”. For example, he noted that “interest spreads for risky assets such as junk bonds and leveraged loans have grown quite narrow”, suggesting that “market participants who are awash in liquidity may be ignoring or taking on outsize potential risks”.

Indeed, in a post at iMFdirect last week, Serkan Arslanalp, an economist at the International Monetary Fund, calls the Fed exit from unconventional monetary policy the “potential shock heard around the world”.

He said that the Fed's exit from unconventional monetary policy could “put upward pressure on long-term bond yields in other economies”. For countries with highly leveraged balance sheets, the rise in long-term yields could “put further pressure on the capacity to service debt and could create headwinds for growth”.

Financial market participants themselves may be recognising the risk. Last week, Bloomberg reported bearish signs in the bond market highlighted by analysts at Morgan Stanley.

This year’s unexpected bond boom may look like a rally, but it doesn’t smell like one.

At least not to Morgan Stanley strategists, who detect something amiss in the way different securities are performing relative to one another.

... Small caps are slumping this year ... while junk-rated securities have gained 4.4 percent.

... The top-tier of speculative-grade bonds is beating the bottom level...

These details “are not entirely consistent with a ‘risk-on’ market,” Morgan Stanley (MS) strategists led by Adam Richmond wrote in a report today. “Given these factors, as well as low volatility, we think hedging credit risk is both cheap and a sensible strategy in this environment.”

So while an improving US economy is generally good news, it comes with its own set of risks for some investors.