Stock market wildcard: What investors need to know as the Fed shrinks the balance sheet faster

By William Watts

Accelerated “quantitative tightening” could fuel volatility, analysts and investors warn

Quantitative easing is credited with juicy stock returns and boosting other speculative assets by flooding markets with liquidity as the Federal Reserve snapped up trillions of dollars in borrowing in the wake of the financial crisis and amid the coronavirus pandemic. Investors and policymakers may be underestimating what will happen when the tide recedes.

“I don’t know if the Fed or anyone else really understands the implications of QT,” said Aidan Garrib, head of global macro strategy and research at Montreal-based PGM Global, in a phone interview.

In fact, earlier this year the Fed began slowly shrinking its balance sheet – a process known as quantitative tightening, or QT. Now it’s speeding up the process as planned and making some market watchers nervous.

A lack of historical experience around the process increases the uncertainty. Meanwhile, research that increasingly credits quantitative easing (QE) with boosting asset prices logically points to the potential for QT to do the opposite.

Since 2010, QE has explained about 50% of the movement in market price-earnings multiples, Savita Subramanian, equity and quant strategist at Bank of America, said in an Aug. 15 research note (see chart below).

“Based on the strong linear relationship between QE and S&P 500 returns from 2010 through 2019, QT would result in the S&P 500 falling 7 percentage points from here through 2023,” she wrote.

Archive: How Much Of The Stock Market’s Rise Is Due To QE? Here’s an estimate

In quantitative easing, a central bank creates credit that is used to buy securities on the open market. Buying long-dated bonds is expected to drive yields lower, increasing appetite for risky assets as investors look elsewhere for higher yields. QE creates new reserves on bank balance sheets. The additional cushion gives banks, which are required by regulations to hold reserves, more leeway to lend or fund trading activities by hedge funds and other financial market participants, further improving market liquidity.

To reflect on the relationship between QE and equities, it should be noted that central banks’ QE increases future earnings expectations. That, in turn, lowers the equity risk premium, which is the extra yield investors demand when holding risky stocks versus safe government bonds, noted PGM Global’s Garrib. Investors are poised to venture further out on the risk curve, he said, which explains the surge in non-yielding “dream stocks” and other highly speculative assets amid the QE spate as the economy and stock market rebounded from the pandemic in 2021.

However, as the economy recovered and inflation rose, the Fed began shrinking its balance sheet in June, doubling the pace in September to its peak rate of $95 billion a month. This is accomplished by rolling $60 billion in government bonds and $35 billion in mortgage-backed securities off the balance sheet without reinvestment. At this rate, the balance sheet could shrink by $1 trillion in a year.

The unwinding of the Fed’s balance sheet, which began in 2017 long after the economy had recovered from the 2008-2009 crisis, should be as exciting as “watching paint dry,” said then Federal Reserve Chair Janet Yellen. It was a ho-hum affair until the fall of 2019, when the Fed had to inject money into dysfunctional money markets. QE then resumed in 2020 in response to the COVID-19 pandemic.

A growing number of economists and analysts have been ringing alarm bells about the possibility of a repeat of the 2019 liquidity crisis.

“If history repeats itself, shrinking the central bank’s balance sheet is unlikely to be a completely benign process and will require careful monitoring of the banking sector’s on-balance sheet and off-balance sheet receivables,” warned Raghuram Rajan, a former Reserve Bank of India governor and former chief economist of the Bank of India International Monetary Fund and other researchers in a paper presented last month at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming.

Hedge fund giant Bridgewater Associates warned in June that QT was contributing to a “liquidity hole” in the bond market.

The hitherto slow pace of unwinding and the composition of the balance sheet contraction have muted the impact of QT so far, but that’s about to change, Garrib said.

He noted that while QT is usually described in the context of the asset side of the Fed’s balance sheet, it is the liability side that matters to financial markets. And so far, reductions in Fed liabilities have been focused on the Treasury General Account (TGA), which effectively serves as the government’s checking account.

This was actually to improve market liquidity, he explained, as the government spends money to pay for goods and services. It won’t last.

The Treasury plans to increase debt issuance in the coming months, which will increase the size of the TGA. The Fed will actively redeem T-Bills if coupon maturities are insufficient to meet its monthly QT balance sheet reductions, Garrib said.

The Treasury will effectively take money out of the economy and put it into the government checking account – a net drain – as it issues more debt. That will put more pressure on the private sector to absorb those Treasuries, meaning less money to invest in other assets, he said.

The concern for stock market investors is that high inflation means the Fed won’t be able to pivot to a dime like it has in earlier periods of market stress, said Garrib, who argued that the Fed’s tightening and other major central banks Banks could prime the stock market for a test of the June lows on a decline that could fall “well below” those levels.

The key takeaway, he said, is “don’t fight the Fed on the way up and don’t fight the Fed on the way down.”

Stocks closed higher on Friday, with the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite posting a three-week streak of weekly losses.

The highlight of the coming week is likely to come on Tuesday with the release of the August CPI, which will be analyzed for signs that inflation is beginning to ease.

-William Watts

(ENDS) Dow Jones Newswires

09-11-22 1723ET

Copyright (c) 2022 Dow Jones & Company, Inc.