As the era of easy money gives way to more aggressive monetary policy, the real risk to markets may not be in rate hikes but in balance-sheet adjustments at the world’s major central banks.

The Fed hiked the federal funds rate by a quarter point on March 15, and it has projected that two more hikes are likely this year. For the time being, we should keep in mind that this outlook does not really depend on anything the Trump administration may or may not do in terms of policy. And in any case, we are more concerned about what kind of leadership the Fed may have next year, when the growth effects of Trumponomics may be clearer. What we find most difficult to forecast is the likely mix of rate hikes and balance sheet contraction if the tightening cycle continues.

We think that the potential unwinding of the Fed’s $4+ trillion balance sheet represents a bigger deal for asset markets than a couple of rate hikes. Trump will have an enormous opportunity to reshape the Fed as vacancies on the Fed’s board of governors open up between April 2017 and February 2018. There is clearly a risk that the people Trump may appoint to the Fed could view the Fed’s balance sheet as evidence of undesirable government “interference” in markets. This is something we will be watching very carefully in the coming months.

We think that the potential unwinding of the Fed’s $4+ trillion balance sheet represents a bigger deal for asset markets than a couple of rate hikes.

Goodbye Haruhiko Kuroda?

At the moment, the Bank of Japan is playing a crucial role in the global interest-rate equilibrium. Its determination to hold the 10-year Japanese government bond (JGB) yield close to zero is a key factor driving capital outflows from Japan. These outflows are helping to keep U.S. rates lower than they would otherwise be. But cyclical dynamics in Japan are improving, and the BoJ is firm in its belief that core inflation is edging higher.

Like the U.S. Fed, the BoJ will have a leadership change next year. BoJ Governor Haruhiko Kuroda has fallen out of favor with Prime Minister Abe, who seems likely not to re-appoint Kuroda to a second term. If Kuroda departs, that could mean the end to experimental quantitative easing at the BoJ, including the near-zero JGB yield constraint. In relatively short order, we will have to start thinking about what new leadership in the BoJ may mean for global rate markets in 2018.

Operation Twist, European style

At the European Central Bank (ECB), President Draghi continues to hold the line against the ECB governing council members who advocate a hawkish stance in the face of a cyclical improvement and a big jump in headline inflation driven by energy and food prices. It is increasingly clear, however, that the ECB’s doves are losing ground, in part at least because Europe’s cyclical economic improvement looks stronger and more balanced. So the debate within the ECB is no longer about battling weakness “as much as it takes for as long as it takes,” but more about when and how to begin the next phase of monetary policy.

The new twist in this debate is the possibility that the ECB might hike its deposit rate before it ends its version of quantitative easing (QE). On first view, this might seem like it would send a contradictory message, but we have to acknowledge that the deposit rate matters for the German banks, whereas QE matters most for the periphery. Moving away from negative rates would mollify some of the hawks, while keeping peripheral yields down would help prevent the emergence of a debt crisis in countries like Italy. It would be the European version of Operation Twist, where the U.S. Fed simultaneously pursued policies of buying and selling short- and long-term debt. But a move on the European deposit rate, even if accompanied by a renewed commitment to purchase assets, would clearly signal a shift in the ECB’s approach.

In conclusion, we could enter 2018 facing major changes in the big three central banks. This will be especially important if U.S. tax reforms create the possibility of faster growth.

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The global economy is close to firing on all cylinders, but coming changes at the world's major central banks warrant caution ahead.