After roughly doubling its balance sheet to $9 trillion after the pandemic, the Fed began shedding some of the Treasury bills and mortgage-backed securities it holds in June, at a rate of $47.5 billion. of dollars. It announced that this month it would accelerate the pace of its quantitative tightening to $95 billion.
The magnitude of the Fed’s easing is unprecedented, and the effects of the end of the central bank’s role as a constant, price-insensitive buyer of treasury bills have so far been difficult to identify in asset prices.
Some investors, however, are reducing equities or fixed-income securities as quantitative tightening gathers pace, fearing that the process will combine factors such as higher interest rates and a surging dollar to further depress equity prices. assets and hurt growth.
“The economy is already on the path to recession and the increased pace of the Fed in terms of QT will accelerate the decline in equity prices and the increase in bond yields,” said Phil Orlando, chief strategist. of the stock market at Federated Hermes, which recently increased its cash allocation to a 20-year high.
The Fed’s monetary policy tightening has weighed on stocks and bonds in 2022. The S&P 500 is down 14.6%, while the benchmark 10-year U.S. Treasury yield, which is moving inversely to price, recently stood at 3.30%, after jumping 182 basis points this year.
Although recent data has shown that the US economy has remained resilient in the face of rising interest rates, many economists believe that the tightening of monetary policy increases the risks of recession next year.
The New York Fed forecast in May that the central bank will reduce its holdings by $2.5 trillion by 2025.
Estimates vary as to what impact this will have on the economy: Orlando at Federated Hermes said that every $1 trillion of Fed balance sheet reduction would equate to an additional 25 basis points of implied rate hikes . Ian Lyngen, head of US rates strategy at BMO Capital Markets, estimates that could add up to 75 basis points through the end of 2023 alone.
At the other end, Solomon Tadesse, head of Quant Strategies for North America at Societe Generale, thinks the Fed will eventually reduce its balance sheet by $3.9 trillion, which equates to about 450 basis points in rate hikes. implicit. The Fed has already hiked rates by 225 basis points and another 75 basis point hike is expected later this month.
“It could be the QT surge that could trigger the next market drop,” wrote Tadesse, who thinks the S&P could fall into a 2900-3200 range.
Next week, investors will be watching August’s consumer price data for signs of a spike in inflation. The Fed will hold its monetary policy meeting on September 21.
Jake Schurmeier, portfolio manager at Harbor Capital Advisors, said the reduced liquidity due to tighter financial conditions is already making it harder to take large bond positions and will likely contribute to greater volatility going forward.
“It gives us a break before we make moves,” he said. Although Mr Schurmeier finds long-dated Treasury bills attractive, he is “reluctant to add more risk until volatility has subsided”, he said.
Timothy Braude, global head of OCIO at Goldman Sachs Asset Management, reduced his equity allocation in anticipation of greater volatility due to Fed quantitative tightening.
“It is very difficult to say which markets are going to be the most affected,” he said.
Admittedly, some investors doubt that quantitative tightening will have a disproportionate effect on the markets.
“The increased pace of QT has been known since the Fed announced its QT plans in May,” UBS Global Wealth Management strategists wrote Thursday. “However, when combined with a hawkish Fed, market sentiment is focused on the higher momentum, although the long-term market impact is not large.”
The energy crisis in Europe, the pace and duration of Fed interest rate hikes, and a possible recession in the United States are likely to outweigh quantitative tightening as market drivers, David said. Bianco, Chief Investment Officer, Americas, at DWS Group.
“We don’t dismiss the risks of QT, but they pale in comparison to the risks of where the Fed raises the overnight rate and how long it has to stay there,” he said. .