The Federal Reserve may be nearing the end of its rate hiking cycle, as inflation cools down and economic growth slows down. However, the central bank still has another policy move that could pose a bigger threat to the stock market: its balance sheet reduction.
The Fed has been shrinking its balance sheet by letting its holdings of treasury and mortgage bonds mature without reinvesting the proceeds. This means that the Fed is effectively withdrawing money from the market, reducing the amount of liquidity available for investors and businesses.
The Fed has reduced its balance sheet by about $900 billion since June 2022, when it started to taper its bond purchases. It currently holds about $7.6 trillion of assets, down from a peak of $8.5 trillion in May 2022. The Fed has not indicated when it will stop its balance sheet reduction, but some analysts expect it to continue until it reaches about $5 trillion.
Fed’s balance sheet reduction is hurting stock performance and economic activity
The Fed’s balance sheet reduction is having a negative impact on the stock market and the economy, according to some experts. They argue that the Fed’s balance sheet reduction is equivalent to a stealth rate hike, as it tightens financial conditions and raises borrowing costs.
According to a research note by Ned Davis Research, the stock market tends to perform poorly when the Fed reduces its balance sheet by more than $38 billion over a four-week period. The note said that when this happens, stocks have struggled at a -3% annual rate since March 2009, when the Fed began its quantitative easing program.
The Fed’s balance sheet reduction also affects the economy by reducing bank reserves, which limits banks’ ability to lend and invest. This could lead to a credit crunch, especially for small businesses and consumers who rely on bank loans. The Fed’s balance sheet reduction could also reduce the demand for treasury and mortgage bonds, which could push up their yields and hurt the housing market.
Fed’s balance sheet reduction may outweigh the benefits of rate cuts
Some investors are hoping that the Fed will cut interest rates soon, as inflation moderates and growth slows down. They believe that lower interest rates will stimulate the economy and boost the stock market. However, some analysts warn that the Fed’s balance sheet reduction may offset or outweigh the benefits of rate cuts.
According to a report by Bank of America Merrill Lynch, the Fed’s balance sheet reduction has a bigger impact on financial conditions than its interest rate moves. The report estimated that every $200 billion of balance sheet reduction is equivalent to a 25 basis point rate hike. This means that the Fed would have to cut rates by more than 100 basis points to offset the effect of its balance sheet reduction so far.
The report also said that the Fed’s balance sheet reduction may limit its ability to cut rates effectively, as it reduces the amount of bonds that the Fed can buy back if it wants to resume quantitative easing. The report said that the Fed may have to resort to other unconventional tools, such as negative interest rates or yield curve control, if it wants to ease monetary policy further.