With the Federal Reserve accelerating the pace of quantitative tightening (QT) this month, some investors fear that the U.S. economy might be forced to bear enormous pressure, leading to a brutal test for stocks and bonds this year.
In order to support the economy, the Fed doubled its balance sheet to nearly $9 trillion during the epidemic, stopped buying bonds in March this year, and gradually began to shrink its balance sheet. After reducing its holdings of U.S. Treasuries and mortgage-backed securities (MBS) at a monthly rate of $47.5 billion in June, the Fed began expanding its balance sheet to $95 billion in September to recoup liquidity injected into the market during the pandemic.
Some investors are trimming positions in stocks and bonds given the accelerated pace of balance sheet drawdowns, fearing that the Fed’s actions will push up interest rates and send the dollar soaring, weighing on asset prices.
Phil Orlando, chief equity market strategist at Federated Hermes, believes that as the U.S. economy heads toward a recession, the Fed’s quicker pace of QT might accelerate the decline in stock prices and push up bond yields. He only recently raised his cash position to a 20-year high.
Stock and bond markets have come under intense pressure as the Fed pushes ahead with quantitative tightening. So far this year,S&P 500 IndexIt has fallen 14.6%, following a previous surge of 182 basis points, the United States 10-year Treasury yieldIt also recently stood at 3.3%.
While data show the U.S. economy remains resilient even in an environment of rising interest rates, many economists believe that monetary tightening is raising the odds of a U.S. recession next year.
The Federal Reserve Bank of New York forecast in May that the Fed’s balance sheet is expected to shrink by regarding $2.5 trillion by 2025, and the market has mixed views on how this will affect the U.S. economy.
According to Orlando of Hermès Investment Management, a $1 trillion reduction in the balance sheet is equivalent to an implied rate hike of 25 basis points (1 yard). Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, said that the size of the balance sheet might reach $3 trillion next year without waiting until 2025.
On the other hand, Solomon Tadesse, head of quantitative strategy for North America at Societe Generale, expects the Fed to eventually shrink its balance sheet by $3.9 trillion, and warns that expanding QT might trigger another wave of declines in the market that might even makeS&P 500 Indexfell to the 2900-3200 point range.
The Fed will announce its interest rate decision on September 21, and investors will pay attention to next week’s August consumer price index (CPI) for signs of inflation peaking.
Jake Schurmeier, a portfolio manager at Harbour Capital Advisors, said tighter financial conditions have led to a slump in liquidity, making it more difficult to hold large positions in bonds, and potentially more volatility ahead.
While he sees long-dated U.S. Treasuries as attractive, he is reluctant to add more risk until volatility eases.
Timothy Braude, head of OCIO at Goldman Sachs Asset Management, is also reducing equity allocations because he expects the Fed’s quantitative tightening to increase market volatility, and it’s hard to say which areas will be more severely affected.
