The Fed’s “quantitative tightening” should weaken stock prices and the economy. It could boost them instead, says one analyst.

By Joseph Adinolfi

The Federal Reserve’s efforts to give the overheated US economy some impetus by draining liquidity from the financial system could have the opposite of their intended effect, according to Bank of America rates strategist Ralph Axel.

Rather than hurting the US economy and undercutting the stock market, the Fed’s shrinking balance sheet and aggressive rate hikes could help savers rake in more income from their roughly $17 trillion in bank deposits, boosting consumption and the wealth effect , instead of dampening them .

That could potentially explain the boost U.S. stocks have received this year, as the S&P 500 is up about 15% since early 2023, according to FactSet data. While those gains have yet to offset a 19.4% decline from 2022, it was the index’s worst calendar-year performance since 2008.

See:The Secret to Stocks’ Success So Far in 2023? An unexpected $1 trillion in liquidity from central banks

The Fed drained some of the liquidity injected during the 2020 pandemic by implementing a program to quantitatively tighten or shrink its balance sheet, either by maturing the bonds it holds or by selling them and reducing the money supply. The Fed’s balance sheet has already shrunk from $8.5 trillion a year ago to $7.7 trillion on Thursday.

In September, the Fed accelerated the pace of its balance sheet reduction to $95 billion a month, with maturing Treasuries accounting for about two-thirds of that amount.

In order to combat the high inflation in the wake of the pandemic, the Fed has continuously raised its key interest rate over the past year. In theory, higher interest rates make it more expensive for businesses and consumers to borrow money, while making highly safe government bonds more attractive relative to risky stocks, slowing investment and economic growth.

But that won’t be the case in 2023, according to Axel.

As the Fed has withdrawn from the bond market, retail investors have stepped up to absorb the slack by buying more newly issued bonds. As a result, more of their money is transferred from cash or bank deposits and crystallized into government bonds, which have yielded their highest interest rates since before the 2008 financial crisis.

Instead of taking money out of the financial system, it shifts the public’s money from one ship to another while increasing the payouts savers receive.

“The key observation here is that the public is spending one form of government debt to buy another. It is an asset swap. As a result, the cash outflow does not actually reduce the public’s financial assets, it only changes the composition of financial assets held by the public,” he said in a note to clients shared by MarketWatch on Thursday.

While the Fed’s rate hikes have put pressure on vulnerable small and medium-sized lenders and contributed to the collapse of Silicon Valley Bank and other US banks earlier this year, savers have benefited after seeing more than almost no return on their cash and cash equivalents Bond holdings have accepted a decade.

However, there is a potential downside for markets: In order to meet its goals of slowing economic growth to fight inflation, the Fed may have to raise interest rates even higher than it might otherwise have done. Axel said prices will likely need to be kept high for longer than markets are currently pricing in.

“Private households do not lose assets through the outflow of liquidity, but exchange their assets for higher-yielding government bonds,” he said. “For the Fed, this means that QT is likely to be less of a contributor to the demand slowdown, entailing greater risk of a higher and longer-term higher Fed rate path than markets currently anticipate.”

According to Axel’s baseline forecast, the Fed’s effective policy rate is likely to peak at 5.6%, which would mean two more rate hikes. The upper band of the Fed’s target rate range is currently 5.25%. While fed fund futures are pricing in rate cuts in late 2023 or early 2024, Axel expects the central bank to keep borrowing costs elevated through May 2024.

-Joseph Adinolfi

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6/23/07 1639ET

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