Markets shudder as Fed QT starts to take shape

(Bloomberg) — Hardliners at the Federal Reserve continued to rattle the financial market Wednesday as investors adjust to a central bank bent on rapidly reducing its $9 trillion in debt holdings.

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Hours before the minutes of the latest Fed meeting are expected to detail how the balance sheet reduction will take shape, US stocks fell more than 1% and Treasuries extended a sell-off that pushed the 10-year yield up by above 2.60%.

The routs began on Tuesday after Fed Governor Lael Brainard, widely regarded among dovish officials, said holdings would be cut “at a rapid pace” as soon as next month. That tone was echoed by Philadelphia Fed President Patrick Harker on Wednesday.

The Fed is expected to raise interest rates by 50 basis points at its May meeting and possibly begin to ease, a position some investors have been warning is not reflected in financial markets, particularly US stocks, which are up almost 5% in the days after the central bank’s rate hike on March 16.

Many investors still have the idea that US policymakers will resist triggering a sell-off in risky assets, the Fed’s so-called put option, according to Ron Temple, director of US equities. and co-head of multi-assets at Lazard Asset Management in New York.

“If you’re at the Fed and you want to tighten financial conditions, that means lower stock prices, wider credit spreads and higher interest rates,” Temple said. “So if anyone thinks the Fed wouldn’t dare lower stock prices, they are sadly wrong.”

Liquidity attraction

Coupled with overly aggressive rate hikes, a faster-than-expected Fed balance sheet wrap-up is a second policy move with the potential to destabilize global markets, investors say. Not only does it mean that a key buyer of Treasuries has disappeared, but the Fed’s shrinking balance sheet drains liquidity from the financial system, potentially resulting in higher borrowing costs and spikes in volatility across asset classes.

“Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably faster than in the previous recovery,” Brainard said, adding that the “limits” put in place to govern the pace of assets roll-off could be “significantly larger” and phased in much faster than last time.

The last time the Fed reduced the balance sheet was in 2017, starting with monthly limits of $6 billion in Treasuries and $4 billion in mortgage-backed securities, rising over the course of a year to $30 billion and $20 billion. But despite the caps, the cut still helped fuel a disruptive rise in repo rates, a cornerstone of short-term funding markets.

Fed Tightening Will Shake T-Bills to Repo Funding Markets

The risk is that the Fed could be underestimating how much tightening will result from the balance sheet reduction, Lazard’s Temple said. He sees problems particularly for tech stocks with valuations that rely heavily on long-term cash flow projections and suggested recent weakness in bank stocks, which are expected to benefit from rising rates, reflects fears. of credit losses in a growth slowdown. .

“The story of the Fed is that they tend to tighten until something breaks,” said Christopher Alwine, head of credit at Vanguard Fixed Income Group.

impact scale

The impact of the Fed’s portfolio reversal is difficult to quantify. Officials have suggested the runoff would be roughly equivalent to just a rate hike, but others are skeptical. Deutsche Bank said its forecasts for a $1.9 trillion balance sheet through the end of 2023, around the higher end of the spectrum, were equivalent to rate hikes of up to four-quarters of a point.

Futures markets are already pricing in the equivalent of almost ten 25 basis point rate hikes by the Fed through early February next year.

“It’s hard for me to say that the market has fully priced in QT,” Tai Hui, chief Asian market strategist at JPMorgan Asset Management, said at a briefing on Wednesday. “However, I feel safe in saying that some of the QT has already been reflected in bond prices.”

Hui expects 10-year Treasury yields to gradually rise to 3% by the end of the year, with a “manageable” impact on technology and healthcare stocks, provided the rise is “orderly.”

Valuation concern

But since stock indices have largely returned to levels prior to the start of the conflict in February, there is a greater potential for prices to fall sharply in an environment of reduced liquidity, according to Pilar Gómez-Bravo, investment officer and director fixed income. at MFS Investment Management in London.

“It would be nice if the initial level of valuations was acceptable,” he said. “It’s quite scary in some cases. What that means to me as an investor is that you have a higher risk of highly correlated moves when things correct and therefore there are gapping price moves.”

Minutes from the Fed’s March meeting scheduled for Wednesday will be closely scrutinized as they are expected to provide more insight into its balance sheet plans.

Brainard’s comments suggest the Fed is going to use quantitative tightening as a tool, a negative for financial assets, said Kevin Muir, a former institutional equity derivatives trader who now writes the MacroTourist newsletter. That will cause financial conditions to tighten more quickly, he said.

“An increase in the pace of QT adjustment should mean lower inventories, wider credit spreads, and a slight reduction in the need for initial increases,” he wrote. “Using the balance sheet as a fine-tuning tool represents a big shift in attitude for the Fed, and it IS NOT priced into the market.”

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