Fed Balance-Sheet Fracas Highlights Confusion Over Market Impact
(Bloomberg) -- Wall Street has become obsessed with the Federal Reserve’s balance-sheet runoff, as investors debate why it’s suddenly roiling markets more than a year after it began.
There’s been no shortage of industry veterans sounding the balance-sheet alarm in recent weeks. DoubleLine Capital Chief Executive Officer Jeffrey Gundlach says the unwind, interest-rate policy and guidance on where the two are headed have resulted in the equivalent of 15 implied tightenings. Billionaire Stanley Druckenmiller has called it a “double-barreled blitz” that could lead to a major policy error. And Guggenheim Partners Chief Investment Officer Scott Minerd has expressed concerns that liquidity constraints could give way to systemic risk.
Others say not so fast. Strategist at Barclays, Royal Bank of Canada and Wrightson ICAP have suggested the unwind’s link to stocks is weak, at best. Still, the S&P 500 Index plunged more than 3 percent in the hours following last month’s Fed meeting after Chairman Jerome Powell said the rundown was on “automatic pilot,” forcing policy makers to re-craft their message on the fly. And U.S. stocks spiked higher Friday amid reports that the Fed is weighing ending the reductions sooner than previously expected.
The extent to which officials are ready to change tack should become clearer Wednesday following the Federal Open Market Committee’s first meeting of the year. A survey of economists ahead of this week’s decision indicates that most don’t expect the central bank to slow or stop the balance sheet run-off this year, while the median forecast for interest-rate hikes is two in 2019. Regardless of what officials signal, though, Wall Street is likely to remain on edge as it comes to terms with what the balance-sheet unwind actually means for markets.
How did we get here?
The Fed’s unprecedented quantitative-easing programs in the aftermath of the financial crisis pumped trillions of dollars into the banking system. It bought bonds from banks and paid for them by crediting their reserves. Now, with the economy on firmer ground, the Fed wants to siphon off that extraordinary liquidity to contain the potential inflationary effects, prevent asset-price bubbles, and replenish its ammunition to fight the next downturn. The central bank has been letting Treasuries and mortgage bonds on its balance sheet roll off, or mature rather than replacing them, since October 2017. The unwind has gradually accelerated to its current pace of a maximum $50 billion a month.
By contrast, the market frenzy over the balance sheet erupted just weeks ago -- a disconnect that raises some eyebrows, particularly among fixed-income practitioners. Wrightson ICAP economist Lou Crandall wrote that “the Fed’s portfolio runoff is a sideshow” for equities, and RBC’s Michael Cloherty has described the impact as “wildly exaggerated.” That said, most agree that more clarity on the process surrounding the Fed’s unprecedented policy maneuver could help.
“The Fed has never done a two-variable experiment at the same time as they’re tightening policy,” said Lisa Hornby, a U.S. fixed-income portfolio manager at Schroder Investment Management. “The market has been scared by the fact that it’s a reversal of the policies that have been happening for years that have helped all risk assets.”
Where is the unwind being most directly felt?
Money markets. The Fed’s crisis-era bond investments created vast excess bank reserves. Post-crisis rules enacted to curb risk-taking have prompted banks to use much of those reserves to meet the more stringent requirements. As the balance-sheet unwind slowly drains liquidity from the financial system, some in the market are suggesting bank reserves are once again poised to become scarce, forcing banks to tap additional funding. Combined with a surge in Treasury-bill issuance -- in and of itself partly driven by the government’s need to replace the Fed as a regular buyer -- that’s helped push key money-market rates higher, especially in the market for repurchase agreements.
“Even though the Fed might be holding rates at 2.40 percent, the clearing rate for repo is much higher than that and I think that’s a result of this quantitative tightening and balance-sheet unwind,” said Bret Barker, a fixed-income portfolio manager at TCW Group in Los Angeles.
What about the impact on riskier assets?
That’s more complicated. The Fed’s purchases suppressed yields on Treasuries and agency mortgage-backed securities, driving investors into higher-yielding assets such as equities and corporate debt. Narrowing credit spreads enabled a record amount of corporate borrowing, which was used in part to buy back shares. Now, as the Fed normalizes policy, some of the tailwinds are reversing. Yields on Treasury bills from one- to six-months have risen to roughly 2.3 to 2.5 percent, more than the 2.1 percent dividend yield on the S&P 500 Index. Some say the additional tightening impact of the balance-sheet unwind may make credit conditions too restrictive, particularly for over-levered companies, and push the economy into recession.
“A lot of it is sentiment more than the fundamentals,” said Sebastien Page, head of global multi-asset strategy at T. Rowe Price in Baltimore. The markets have “gone through massive liquidity injections and the building up of those balance sheets. So what investors are worried about is the change in direction, so you go from rates going down and liquidity going up, to rates going up and liquidity going down.”
Where does the balance sheet unwind go from here?
It’s fair to say no one -- not even the Fed chairman -- can say with certainty what the balance sheet will look like in a year’s time. The most recent New York Fed survey shows primary dealers expect it to stabilize at about $3.5 trillion, which at the current rundown rate implies an end to the unwind in early 2020, according to analysis from ABN Amro Bank. Just three weeks ago, Powell said the future balance sheet “will be substantially smaller than it is now,’’ and encountered yet another wobble in stocks. More recent public statements from central-bank officials suggest policy makers are considering stopping the runoff sooner rather than later.
Another point of contention is whether the portfolio will still include mortgage-backed bonds. Nomura’s head of Americas fixed-income strategy George Goncalves expects a “full roll-off of the legacy MBS book but also a shift to a short U.S. Treasury duration portfolio.”
Amid all this uncertainty, a couple of things about the balance sheet are clear. Markets will have to accept that -- at least for the remainder of this economic cycle -- the days of maximum policy accommodation are over. In the meantime, will have to be wary of drawing attention to the autopilot and take full control of the market narrative.
©2019 Bloomberg L.P.