NEW YORK (Reuters) – As the Federal Reserve expands its balance-sheet liquidation this month, some investors are concerned that so-called quantitative tightening will weigh on the economy and make this year even worse for stocks and bonds.
In June, after virtually doubling its balance sheet to $9 trillion during the crisis, the Federal Reserve began selling off some of the Treasuries and mortgage-backed securities it holds at a rate of $47.5 billion per month. It has said that this month it will raise quantitative tightening to $95 billion per month.
The Fed’s unwinding is on a scale that has never been seen before, and it has been hard to tell what effect the central bank’s decision to stop being a constant, price-insensitive buyer of Treasuries has had on asset prices so far.
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As quantitative tightening speeds up, though, some investors are reducing their exposure to stocks and fixed income because they are afraid that the process, along with factors like rising interest rates and a strong dollar, will make asset prices fall even more and hurt the economy.
Phil Orlando, chief equity market strategist at Federated Hermes (NYSE:FHI), recently increased his cash allocation to a 20-year high. He said, “The economy is already on a glide path to recession, and the Fed’s quickening pace in terms of QT will speed up the drop in stock prices and rise in bond yields.”
In 2022, the Fed’s stricter monetary policy will have a negative impact on stocks and bonds. The S&P 500 is down 14.6%, yet the yield on the benchmark 10-year U.S. Government bond is up. Treasury yields, which move in the opposite direction of prices, rose 182 basis points this year to reach 3.30 percent.
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Recent data show that the U.S. economy has been strong even as interest rates have gone up. However, many analysts believe that tighter monetary policy will make a recession more likely next year.
In May, the New York Fed forecast that the central bank would reduce its assets by $2.5 trillion by 2025.
Estimates vary as to how this will impact the economy. Orlando, at Federated Hermes, estimated that every $1 trillion in Fed balance sheet reduction would result in an additional 25 basis points in implied rate hikes. Ian Lyngen, the head of U.S. rates strategy at BMO Capital Markets, predicts that it might add up to 75 basis points by 2023’s end.
Solomon Tadesse, head of North American Quant Strategies at Societe Generale (OTC:SCGLY), expects the Fed will ultimately reduce its balance sheet by $3.9 trillion, corresponding to around 450 basis points of implied rate rises. The Fed has already raised interest rates by 225 basis points, and they are expected to go up by another 75 basis points later this month.
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“The increase in QT could cause the next market decline,” Tadesse stated, predicting that the S&P could fall to a range of 2900-3200.
Next week, investors will closely monitor August consumer price data for indications that inflation has peaked. On September 21, the Fed will convene its monetary policy meeting.
Jake Schurmeier, the portfolio manager at Harbor Capital Advisors, said that the lack of liquidity caused by tightening financial conditions is already making it harder to take big positions in bonds and will almost certainly lead to more volatility in the future.
“It gives us pause before we act,” he explained. Schurmeier thinks that longer-term Treasuries are attractive, but he doesn’t want to take on more risk until the market becomes less volatile.
Timothy Braude, who is the global head of OCIO at Goldman Sachs (NYSE:GS) Asset Management, has been reducing his allocation to stocks because he thinks the Federal Reserve’s quantitative tightening will make the market more volatile.
“It is quite difficult to predict which markets will be most affected,” he said.
Certain investors doubt that quantitative tightening will have a disproportionate impact on the markets.
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Since the Fed unveiled its QT plans in May, the acceleration of QT has been known, strategists at UBS Global Wealth Management noted on Thursday. “However, when coupled with a hawkish Federal Reserve, market sentiment concentrates on the higher rate, even though the long-term impact on the market is negligible.”
The oil crisis in Europe, the pace and duration of the Fed’s interest rate hikes, and the possibility of a U.S. recession are likely to outweigh quantitative tightening as market movers, according to David Bianco, chief investment officer, Americas, at the DWS Group.
“We are not disregarding the dangers of QT, but they pale in comparison to the risks associated with where the Fed raises the overnight rate and how long they must remain there,” he said.
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