Stock markets, beaten down in recent weeks by trade disputes and concerns over a potential slowdown in US growth, found a new catalyst for selling activity on Wednesday.
The S&P 500 (.SPX) lurched lower after Federal Reserve chairman Jay Powell said he saw no reason for the central bank to change its plans to reduce the size of its balance sheet.
The benchmark equity index had already slipped by a little over 1 per cent from its high for the day between the Fed announcing its decision to increase interest rates at 2pm and the start of the planned press conference at 2.30pm. Subsequent moves lower of around 1 per cent and almost 2 per cent lined up with Mr Powell’s response to questions on the Fed’s balance sheet, contributing to an overall decline of 1.5 per cent by the close of trading. Markets in Asia and Europe also balked.
But why? What does the Fed’s decision to stop replenishing its stock of Treasuries and mortgage-backed securities (MBS) have to do with equity markets? And why are investors so concerned?
1. What is the Fed doing?
In the wake of the financial crisis, the Federal Reserve sought to prop up markets by purchasing US Treasuries and MBS, racking up holdings of about $4.3tn in a programme known as “quantitative easing”. The idea was simple: by increasing demand for these safer assets, prices would rise (and interest rates would fall). This not only eased financial conditions by helping reduce borrowing rates, but also pushed investors into buying riskier stocks and corporate debt in order to find better returns.
As the economy recovered, the Federal Reserve saw less need to continue propping up prices by holding on to these assets and at the end of 2017, the central bank began to gradually reduce the size of its balance sheet by allowing maturing Treasuries and MBS to run off, rather than being replaced.
Since then, the size of the Fed’s holdings has reduced to about $3.9tn, with the pace of the reduction accelerating over time.
2. Why are investors concerned?
If the growth of the Fed’s balance sheet encouraged investors to buy stocks and corporate debt, supporting the price of riskier assets, then in theory, as the Fed ratchets up the reduction of its balance sheet, the inverse will be true and stock and bond prices will fall.
Instead of quantitative easing, the Fed is embarking on “quantitative tightening”.
“If the Fed is buying Treasuries, investors have to go further out the risk spectrum in search of returns,” said Subadra Rajappa, head of US interest rate strategy at Société Générale. “So if the Fed is unwinding QE then the reverse should be happening. It should be negative for credit spreads and equities.”
3. Early warning signs
So far, the effects have been limited, or at least outweighed by bigger market drivers. It is difficult to gauge the impact of the Fed’s balance sheet unwind on recent volatility in stocks and corporate bonds that has been more readily attributed to a cocktail of trade concerns, fears of slowing growth and rising interest rates.
“It is amplifying what is already occurring,” said Kristina Hooper, chief global market strategist at Invesco.
Some cracks have emerged in short-term lending markets that lubricate the supply of dollars through the financial system, said analysts. After the crisis, the Fed bought assets by crediting banks’ reserve accounts, increasing the cash available for short-dated lending activity. As the Fed’s assets decline, so do bank reserves, reducing the money available for things such as overnight repo trades, where cash is lent in return for Treasuries, or commercial paper issuance, where corporates can borrow cash for short periods.
Earlier this month, players in the repo market were willing to pay banks 25 basis points more than they could earn leaving their cash at the Fed, according to a rate compiled by the Depository Trust & Clearing Corporation. That is the highest spread since 2015, outside of a month or quarter end — where funding pressures have been more common.
4. What did Mr Powell say?
The lack of any clear market fallout stemming from the balance sheet unwind has previously been noted by policymakers and, in response to questions on Wednesday, Mr Powell gave no indication that the central bank was considering any shift on its current policy.
“Some years ago, we took away the lesson that the markets were susceptible to news about the balance sheet, so we thought carefully about how to normalise it and thought to have it on automatic pilot and use rates to adjust to incoming data,” he said. “That has been a good decision, I think. I don't see us changing that.”
5. What do investors think?
With no sign of let-up from Mr Powell, additional tightening from the Fed’s balance sheet unwind will be added to a list of existing worries for 2019.
“It was unsettling to hear that come out of Chairman Powell’s mouth today,” said Ms Hooper.
Some investors also point to the increasing US budget deficit as compounding the effects. Roughly $271bn of Treasuries are expected to run off the Fed’s balance sheet next year and will instead be bought by other investors, compared with additional supply of $856bn resulting from other government funding needs, according to analysts at Société Générale. But for investors, there is little control over the latter, whereas the Fed could help to curtail the former.
“I think the Fed is missing the bigger picture with regard to the balance sheet,” said Gene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle Investments. “If you believe that QE helped financial markets, you cannot believe that unwinding that will do nothing.”