On Wednesday, the Federal Reserve said it would start reducing its balance sheet “relatively soon.” Though the central bank’s policy update was mundane, the reduction of its asset portfolio is closely followed because it has the ability to roil Treasury markets, given its scale.
See: Fed to wind down bondholdings ‘relatively soon’
Here’s how some Wall Street strategists expect the market to react to the Fed’s shrinking assets, which can have the effect of adding to its efforts to tighten monetary policy:
Goldman Sachs Group Inc.’s strategist predict that Treasury prices will fall, pushing the 10-year yield
up. Goldman forecast that the 10-year yield will rise an additional 20 basis points in 2017, assuming reductions kick off this year as predicted. Then, the bank sees an annual increase of 12.5 basis points in yields over the following two years. Bond prices and yields move inversely.
But making predictions tricky is the unprecedented nature of the Fed’s plans as it looks to normalize monetary policy following the 2008-’09 financial crisis, which forced central banks across the globe to unfurl easy-money policies to buoy domestic economies. Since December 2015, the Fed has been lifting rates and has been creeping toward unloading its crisis-era balance sheet.
Applying a model from the Fed, Goldman has sought to understand the ramifications of erasing the legacy of extraordinary monetary policy. Researchers at the board of governors of the Fed had estimated quantitative easing was worth a term premium of a 100 basis points. A term premium represents the extra yield investors demand for holding longer-term and potentially less liquid securities.
Analysts also say stocks and other assets perceived as risky could come under selling pressure amid Yellen & Co.’s asset unwind. After global central banks embarked on quantitative easing, investors were forced out of bonds into equities and high-yielding debt, also known as junk bonds, as they sought deliver richer returns. Against that backdrop, the Dow Jones Industrial Average
the S&P 500 index
and the Nasdaq Composite Index
are all trading at or near all-time highs.
“Shrinking the balance sheet is likely to reverse the portfolio rebalancing effects of quantitative easing—which lowered the market supply and increased the prices of risky assets—on asset prices,” said Daan Struyven, economist at Goldman Sachs in a research note earlier this week.
Also read: Jamie Dimon says QE unwind could catch investors by surprise
But the prospect of the Fed draining liquidity from financial markets hasn’t hurt stocks, government paper and corporate credits so far. In fact, they have largely shrugged off the prospect of a balance sheet runoff. Part of this is down to the Fed telegraphing its intentions to a tee as investors now know how and by how much the central bank intends to cut its portfolio.
“The equity markets are not going down, in any significant manner, at any time in the foreseeable future. It’s the flow of money, not earnings, that is driving the bus,” wrote Mark Grant, chief strategist for Hilltop Securities, in a blog post.
That said, some money managers argue that the absence of a strong market reaction reflects a degree of complacency, perhaps making the market’s reaction even more unpredictable.
“Even if it’s going to be a slow, uneventful reduction in the beginning, it accelerates pretty quickly,” said Mike Collins, senior investment officer at PGIM Fixed Income. He noted the size of the runoff increases every month, speeding up to an annual pace of $600 billion after the first year.