While the Federal Reserve (the Fed) may be approaching the conclusion of its series of rate hikes, another policy maneuver still presents a significant concern for the stock market: its ongoing balance sheet reduction efforts.
Over the past year, the Fed has effectively reduced its balance sheet by an impressive $900 billion, and there are no apparent indications of a slowdown.
In a recent note, Ned Davis Research underscored the importance of liquidity for risk assets. The process of ongoing liquidity drainage through monthly reductions in the balance sheet could introduce a level of risk to equities and other assets.
Despite the probability of the Fed winding down its rate hikes due to a cooling inflation trend, the central bank’s quantitative tightening strategy, involving the gradual unwinding of its balance sheet, could pose a considerable threat to stock prices and other risk-associated assets.
Since June 2022, the Fed has successfully brought its balance sheet down by $900 billion to $7.6 trillion, a figure that would have been even larger if not for a $400 billion liquidity injection deployed to manage a regional banking crisis in March.
The strategy behind the reduction involves allowing the maturity of treasury and mortgage bonds without reinvesting the proceeds, which inevitably withdraws liquidity from the markets.
Joseph Kalish, Chief Global Macro Strategist at Ned Davis Research, emphasized the vital role of liquidity in financial markets. He noted, “Liquidity is the lifeblood of the financial markets… Risk assets love liquidity. Continued draining of liquidity presents a risk for equities and credit.”
NDR’s analysis unveiled a pattern: a $62 billion or more increase in reserves over a 4-week period correlates with explosive stock returns at a 31% annual rate since the commencement of the Fed’s quantitative easing (QE) escalation and the shift to an ample reserves framework in March 2009.
Conversely, a decline of more than $38 billion in reserves over the same timeframe has typically coincided with stock market struggles.
Therefore, the implications are that even if the Fed puts an end to its interest rate hikes later this year, the stock market could still face challenges due to the ongoing balance sheet reduction program.
The Fed has yet to demonstrate any intention of halting this initiative, which can wield a substantial influence not only on equities but also on the broader economy.
Chief Global Macro Strategist Joseph Kalish noted that the contraction of securities diminishes bank reserves, impacting their cash reserves and subsequently constraining their capacity to extend loans and make investments.
This dynamic, combined with the pronounced interest rate increases over the past year, contributes to the tightening of credit conditions and a reduced inclination of banks to lend.
As the year unfolds, the question of whether the Fed’s persistent tightening measures will curtail the current stock market rally remains unanswered.
(Original Article Source: Barrons)
