All this comes against the risky backdrop of the Fed hiking interest rates at the fastest pace in decades to combat red-hot inflation, as officials seek to quash talk of a September pause.
Gyrations in stocks, bonds and other markets have done little to deter the US central bank from its hawkish posture, with policymakers widely expected to raise rates by another half point on June 15. The Fed began shrinking its balance sheet this month by allowing assets to mature without reinvestment at a monthly pace of $US47.5 billion, increasing to as much as $US95 billion a month in September.
“It’s where that quantity of capital and quantity of liquidity has been most beneficial that its withdrawal is going to continue to be felt – and that is in the most speculative parts of the market,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said on Bloomberg Television.
The MLIV survey of most-at-risk assets in the QT era canvassed a group ranging from retail investors to market strategists. Just 7 per cent picked mortgage-backed bonds – securities that were at the heart of the 2008-09 meltdown – with almost half citing tech and crypto.
Draining money from the system tends to tighten financial conditions, all else equal, which acts as a brake on economic growth. That can reduce valuations for tech stocks given their reliance on optimism about future profits.
The end of Fed bond-buying also forces the Treasury to sell more debt in the open market, potentially putting upward pressure on bond yields, which play a big role in how Wall Street values listed companies – a headwind for so-called growth stocks in particular.
Fuelled by pandemic-era policy easing, the tech-heavy Nasdaq 100 Index climbed more than 130 per cent from its March 2020 low before plunging this year.
Meanwhile, cryptocurrencies have increasingly been driven by fluctuations in tech stocks. Since March 2020, there has been a strong positive correlation between bitcoin and the Nasdaq 100, with the relationship intensifying in this year’s sell-off.
Effect on junk bonds
The thinking goes that when money is cheap, traders can speculate about future digital trends en masse. But when the liquidity party fades, those bets become more costly.
“I don’t think people fully realise how much QE caused investors to add a lot of leverage to their positions,” says Matt Maley, chief market strategist for Miller Tabak + Co. “Now that we’re going through QT, that leverage has to be unwound.”
Respondents who were active in the market during the financial crisis more than a decade ago are particularly concerned that the Fed’s balance-sheet shrinkage will hurt junk bonds. Newer entrants are more inclined to worry about its impact on crypto and tech shares.
Readers more broadly are sounding the alarm about global trading conditions as the likes of the European Central Bank – which meets this week – and the Bank of England look to rein in their expanded balance sheets. Nearly 53 per cent say they’re concerned markets are underestimating the liquidity importance of central banks outside the US.
Only 8 per cent described QT in general as overhyped. Yet the principal concern of MLIV readers remains how far the US central bank will lift benchmark borrowing costs in this cycle. Some 61 per cent say the level at which the terminal fed funds rate peaks is more important than the amount by which the balance sheet shrinks.
As for QT’s end game, about two thirds say the primary catalyst is more likely to emerge from negative developments than victory on the inflation front. Some 38 per cent say economic pain would prompt an end to the balance-sheet rundown, while 20 per cent point to market turmoil.
Just 10 per cent voted for problems related to bank reserves and short-term funding markets. That’s an implicit vote of confidence in the measures the Fed has taken to avert logjams in the financial plumbing that caused it to intervene in 2019 during its previous tightening program.
For many, the era of ultra-low rates and big central bank balance sheets is all they’ve known professionally. Some 46 per cent of MLIV respondents weren’t active in markets before the widespread global adoption of quantitative easing in the aftermath of 2008.
Fewer still rode the early long-dated Treasury bull market in the decades past. A strong majority of readers – 64 per cent – say the four-decade bullish stretch has finally ended, with experienced market players notably more hawkish than younger counterparts.
“Whenever you’re seeing major shifts in liquidity, there’s potential you could see some disruption in the market and that could trigger some violent trading behaviour,” says Ed Moya, senior market analyst at Oanda.
Bloomberg
