There continues to be two fundamental risks or debates in financial markets: China’s convergence to pseudo-normal growth; and monetary policy normalization. Additionally, there is geopolitical noise, which has re-emerged in the last few weeks, and it matters at high frequency, but it is unlikely to have an effect on the global business cycle.

Monetary policy in G4 countries, especially in the US, is probably the key debate for the second half of this year. The Fed is expected to spell out in some detail its exit strategy by the end of August (at Jackson Hole), which is clearly still a work in progress. The Fed minutes recently released show an active debate within the Fed, and work in progress on which new tools to introduce and what type of rate to use once the Fed decides to move towards a more normal monetary policy. Tapering is expected to be done by October, which means the Fed’s balance sheet would stop growing at a fast pace. Most likely the next step would be to stop purchasing securities with the cash flows generated by the current stock of securities, which means the balance sheet would then start to shrink very very slowly by attrition. What to do next and how is the key question. As we said many times, we are in uncharted territory, with the Fed’s balance sheet more than 4.5 times what it was pre-crisis, the Bank of England’s more than 4 times, and the Bank of Japan potentially trending there. There are no theoretical or empirical roadmaps on how plan the exit to minimize economic and financial disruptions. We tend to believe the market exaggerates the importance and influence of monetary policy, but we need to take it as what it is and plan accordingly.

The Fed debate on whether to use a new interest rate, before or after doing reverse repos to mop up liquidity, and when in that sequence to stop using cash flows to buy other assets is to some extent a dance to avoid discussing the size of the balance sheet and the only way it will normalize: attrition or selling assets (the ‘S’ word the Fed would not dare to mention). Financial markets would clearly freak out if the Fed were to use the ‘S’ word. The Fed would only SELL assets last. It is clearly the case that the Fed is trying to be smooth, to create the expectation of a very gradual process. Many large investors have recently voiced concern the Fed is behind the curve, which begs the question whether this is not also part of the strategy. Let inflation rise, let it ride for some time (which has some fiscal benefits) and then embark in a normalization process. Obviously this is all easier in an environment in which growth trends towards 3-4% as opposed to the current fear of being stuck below 2%. If inflation continues to recover or rise while growth stays low, the Fed would be in a real bind.

What, how and when the Fed will move towards normalization is clearly the key policy question for international financial markets. Last year’s ‘tapering’ episode showed how markets react when surprised about the policies around the Fed’s balance sheet. The fact that ‘tapering’ did happen without further effects can be taken as a signal that gradually markets adapt to these changes. Actually, interest rates have stayed surprisingly low through ‘tapering’, and a lot has to do with disappointing growth in most of the global economy, but especially in the US and Europe. Then there are issues of coordination and timing. The Fed and the Bank of England are bound to move in the same direction, while the European Central Bank and the Bank of Japan are bound to move in the opposite direction for a while. The rest of the world is in the middle. This will create for interesting financial and economic events.

For the time being, the first event is further details on the exit strategy at the Fed. Unless economic fundamentals were to improve at a much better pace than currently, that debate is bound to produce noise and volatility in the markets, especially given current levels. Enough of a reason to reduce risk at this juncture.