US economy

Fed draws loudest market cheer on balance sheet shift


The Federal Reserve’s efforts to shrink its balance sheet last year morphed from something investors saw as a near irrelevance to a burning concern. In their first meeting of the year, central bank policymakers grudgingly tried to mollify them.

On the eve of the financial crisis the Fed’s balance sheet was well under $1tn, consisting largely of short-term Treasury bills. A decade on, and a succession of quantitative easing programmes later, the balance sheet had swelled to a peak of $4.5tn as the Fed accumulated vast amounts of Treasuries and mortgage-backed bonds to help ward off another depression.

Last year the central bank began to slowly reduce its balance sheet by letting some of the bonds it held mature without reinvesting all the money back in the market, a process officials repeatedly promised would prove as “boring as watching paint dry”. It proved anything but.

The initial phlegmatism of fund managers and traders gave way to anxiety about “quantitative tightening”, as the size of the balance sheet approached $4tn last year, creating some strain in short-term funding markets. In the view of many investors, the balance-sheet shrinkage contributed to the worst December for US equities since the 1930s.

“The whole ‘nothing to see here’ mantra on the balance sheet didn’t work,” said Gregory Peters, a senior portfolio manager at PGIM Fixed Income. “People believe what they wanted to believe, but the slow unwind and the rate increases finally started to bite.”

The Fed has been sceptical of this argument, but on Wednesday officials formally confirmed it would be willing take its balance sheet shrinkage policy off autopilot, if conditions warranted. Markets loudly cheered the decision, with the S&P 500 now on track for its best start to a year since 1987 and US government bonds rallying.

Disentangling the effect of the Fed’s sudden openness to revisiting its policy of shrinking its balance sheet from the more cautious tone it also struck on interest rates is not easy. Krishna Guha, vice-chair of Evercore ISI, described it as a “market-friendly dovish blast with both barrels of the shotgun”.

Yet the Fed’s shift in balance sheet policy was probably the biggest fillip, given how sensitive investors had become to the issue. This was vividly illustrated at the Fed’s December meeting, when US stocks tumbled after chairman Jay Powell had simply reiterated the longstanding mantra that the shrinkage was on autopilot.

Rick Rieder, head of fixed income at BlackRock, has long maintained that the combination of rate increases, balance sheet shrinkage and a US government borrowing splurge that has lifted bond issuance could prove toxic. The Fed’s new, more cautious stance is the right one, he says.

“We are seeing a more rapid deceleration in global liquidity than many anticipated, resulting from multiple sources,” Mr Rieder argued. “In the US, this takes the form of ‘triple-barrelled tightening’, which is comprised of: higher policy rate levels, Fed balance sheet reduction, and an unprecedented amount of US Treasury issuance.” 

On one hand, it is logical that quantitative tightening should unsettle markets. After all, the argument behind QE had been that it would have a “portfolio rebalancing” effect, with the Fed’s buying forcing investors to buy riskier assets, thereby supporting markets and economic growth. As QE is reversed, markets should, in theory, deflate as investors pick up the slack left by the retreating Fed.

However, it begs the question why shrinking the balance sheet was deemed a non-event. After all, investors have known the pace of the Fed’s balance sheet reduction since the middle of 2017, and managed to digest the process without any hiccups.

Mr Peters argues that it was primarily equity investors that were initially blind to the consequences, but eventually had to recognise reality as the balance sheet shrinkage started to accelerate in the second half of 2018 — even as the Fed kept raising rates and the European Central Bank prepared to end its own QE programme.

“Fixed income people had been talking about this for ages and no one cared. And then for some reason the balance sheet question took on a life of its own,” Mr Peters says.

Many investors and analysts remain divided — or at least uncertain — over whether and to what extent the Fed’s balance sheet shrinkage really had an impact on last year’s market ructions. Regardless, the central bank on Wednesday clearly signalled that it was aware of the concerns, and indicated that it would henceforth be willing to use the balance sheet as a more active policy tool if necessary.

That reinforced the dovishness of its current stance. Perhaps as importantly, the Fed also revealed that it would not be returning to its pre-crisis monetary policy toolkit, which would imply a much smaller balance sheet. As a result, some economists now expect its QT programme to be slowed down and perhaps ended by the end of 2019.

That would be unambiguously positive for financial markets. “With the Fed now saying policy is ‘appropriate’ and it needs to see a reason to hike again, US central bank support for global risk may prove to have some legs,” Mr Guha noted.



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