Wall Street Is Divided on Impact of Fed's Balance-Sheet Runoff

(Bloomberg) -- The Federal Reserve’s balance-sheet runoff was supposed to be as dull as watching paint dry. Instead, it’s moving the U.S. stock market, sparking a debate on Wall Street about the logic of such reactions and whether there’s any real link between equities and the central bank’s shrinking $4 trillion portfolio.

Joseph Abate of Barclays Plc says the correlation isn’t solid, while Morgan Stanley strategists say the unwind is having a big effect on market dynamics. In fact, analysts at the New York-based bank have even developed a quantitative model showing that the S&P 500 Index would drop 3.3 percent this year if the Fed continues its current pace of mortgage-backed debt runoffs.

The impact was evident last week, when comments from Fed Chairman Jerome Powell that the central bank balance sheet “will be substantially smaller than it is now” fueled a slide in stocks. That came just three weeks after a perceived lack of flexibility with regard to the unwind during his post policy-meeting press conference sent shares into a tailspin.

Below is a roundup of Wall Street’s views:

• Barclays (Abate)
  • The link between the Fed unwind and stock selloff “is weak”
  • The argument that normalization and resulting reduction in bank reserves is contributing to lower equities isn’t very strong; the flow of reserves may matter more for share prices than the absolute level
  • MORE
• Citigroup (Jabaz Mathai, Steve Kang)
  • Investors care about the Fed’s flexibility with the balance sheet because it implies a “faster turn” toward rate cuts
  • “We don’t presume to settle the debate on QE/QT impacts”; however, correlations among equities, credit markets with the Fed’s balance sheet were not any better than with economic data, such as PMI
  • “Our conclusion is that asset markets are driven by economic fundamentals, as much as changes in balance sheet assets and liabilities”
• Morgan Stanley (Matthew Hornbach, Sam Elprince, others)
  • Balance sheet is playing an important role in market dynamics
  • The impact was evident during the market volatility of late 2018, and has likely been exacerbated by the normalization of rates
  • An early end to normalization will become less surprising to investors over the next six months; MORE
• RBC (Michael Cloherty)
  • No real link exists between Fed’s balance-sheet runoff and risk-asset decline; the perceived impact of quantitative tightening on stocks and credit spreads is “wildly exaggerated”
  • Further balance-sheet declines do not suggest additional weakness in risk assets
  • The market’s recent tendency to link these two things will put more pressure on the Fed to clarify its approach to monetary policy and “give some indications about the ultimate size of the balance sheet”; MORE
• Wrightson ICAP (Lou Crandall)
  • Fed’s balance sheet may be a “point of contention”
  • If “alternative narrative” that the balance sheet is squeezing the stock market gains traction, “it will be harder for Fed officials to stick with the ‘watching paint dry’ metaphor that had served them well until recently”; MORE
  • Portfolio unwind is “immaterial” to equity selloff and is not a a major driver of broader capital market trends
  • “The quasi-monetarist view that more bank reserves mean more money to buy stocks doesn’t hold up”; MORE

To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Boris Korby, Mark Tannenbaum

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