With the Federal Reserveâs program to shrink its bloated balance sheet under way, some investors are blaming the reduction of that crisis-era portfolio for the stock marketâs sharp slide from its October peaks. However, Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets, says investor fears around the process known as quantitative tightening are overblown.
Such concerns on Friday compelled Federal Reserve Chairman Jerome Powell â and other senior Fed officials earlier â to qualify earlier statements about those plans, by suggesting that the central bank might tweak the rate of reducing the $4.1 billion reduction, if it deems that the process is fueling adverse conditions in financial markets.
In a note on Thursday, Cloherty pushed back against arguments that the balance sheet, which was increased as the central bank sought to stave off the worst of the 2007-09 financial crisis, is creating problems. Some market participants said the portfolio shrinkage has amplified volatility in a market already fragile after nine interest rate hikes since the end of 2015.
The S&P 500
and the Dow Jones Industrial Average
are down more than 10% from their all-time highs, while the Nasdaq Composite Index
Â slid into bear-market territory in December, usually defined as a drop of at least 20% from a recent peak.
âThe [quantitative tightening] impact on risk assets is wildly exaggerated, and further balance sheet declines do not suggest additional weakness in risk assets,â he said.
From the start, the Fedâs balance sheet was viewed as a controversial policy tool, one that some market participants feared might foster distortions in corners of the financial world.
However the magnitude of the financial crisis a decade ago underpinned the unusual measure, which saw the Fedâs portfolio of securities increased from less than $1 trillion in 2007 to $4.5 trillion in 2014. With the central bank now normalizing monetary policy, the Fed has gradually unwound it by not reinvesting the proceeds from maturing securities, a process described as quantitative tightening or QT.
See: Why stock-market bulls may soon be complaining about the Fedâs quantitative tightening
Higher risk-free yields
Analysts say quantitative easing had inflated prices for stocks and corporate bonds by lowering long-term yields for U.S. government paper, driving investors hungry for richer returns to relatively riskier assets, including stocks.
It therefore stands to reason that quantitative tightening would hurt risk assets by driving up yields to more attractive levels, drawing investors away from stocks and back to so-called risk-free Treasurys and government-sponsored mortgage-backed securities.
Though, there is some debate as to how QT increases bond yields, Cloherty says the transmission mechanism is that a shrinking balance sheet effectively increases the supply of debt to the bond market. Yields then climb to levels that may be deemed appetizing enough for investors to digest the flood of government paper.
But when the S&P 500 began its slide, yields didnât rise. In fact, the 10-year Treasury yield
fell from a multiyear high of 3.26% to levels last seen in Jan. 2018, when fears around the inflationary effect from President Donald Trumpâs late-2017 tax cuts sparked a selloff in U.S. government paper. Bond prices move in the opposite direction of yields.
âPortfolio investment decisions are made off prices, and yields on low-risk assets remain low,â said Cloherty.
During quantitative easing, the Fed bought banksâ stockpile of U.S. government paper to increase reserves, a move aimed at allowing embattled financial institutions to take on more risky investments and ramp up lending to the broader economy.
In quantitative tightening, the central bankâs reserves would shrink, theoretically, reducing the ability of banks to take on greater risk by investing in risky assets.
âSince the low risk assets created by QE (or destroyed by QT) show up on bank balance sheets, this would suggest that the swing in risks driving risk asset price swings would be happening on bank balance sheets,â said Cloherty.
But even when quantitative easing was under way, the Dodd-Frank Act and other regulatory constraints prevented banks from taking excessive risks with their own balance sheets, with trading desks less willing to hold higher-risk assets like corporate debt on their books.
The power of QT on Wall Street could simply come from its reflection of the Fedâs policy stance, Cloherty argues. By ramping up the pace of the balance-sheet reduction, the central bank could be flagging its intention to raise interest rates.
Yet traders have confused the Fedâs quantitative tightening with the outlook for interest rates. Though the Fedâs balance sheet reduction has reached its peak, rolling off $50 billion every month, expectations for higher interest rates in 2019 have been dramatically altered from just a few months ago. Eurodollar markets, which had been pricing in two rate increases in 2019 are now reflecting expectations for a rate cut this year.
âQT is a signal of less accommodative central banks, but that signal should be reflected in higher expectations for fed funds,â said Cloherty.
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