Wall St Week Ahead-More worries for U.S. stocks, bonds: Fed ramps up ‘QT’

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NEW YORK — As the Federal Reserve accelerates the unwinding of its balance sheet this month, some investors worry that so-called quantitative tightening may weigh on the economy and make this year even more brutal for stocks and bonds.

After roughly doubling its balance sheet to $9 trillion after the pandemic, the Fed began unloading some of the Treasuries and mortgage-backed securities it holds in June at a pace of $47.5 billion. It has announced that this month it is ramping up the pace of quantitative-tightening to $95 billion.

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The scale of the Fed’s unwinding is unprecedented and the effects of the central bank ending its role as a consistent, price-insensitive buyer of Treasuries has so far been hard to pinpoint in asset prices.

Some investors, however, are cutting back equities or fixed income as quantitative tightening accelerates, wary that the process could combine with factors such as higher interest rates and a soaring dollar to further weigh on asset prices and hurt growth.

“The economy is already in a glide path to recession and the Fed’s quickening pace in terms of QT will accelerate the decline in stock prices and increase in bond yields,” said Phil Orlando, chief equity market strategist at Federated Hermes, who recently increased his cash allocation to a 20-year high.

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The Fed’s tighter monetary policy has weighed on stocks and bonds in 2022. The S&P 500 is down 14.6%, while the yield on the benchmark 10-year U.S. Treasury, which moves inversely to prices, recently stood at 3.30%, after surging 182 basis points this year.

Although recent data have shown the U.S. economy has remained resilient in the face of higher interest rates, many economists believe tighter monetary policy is increasing the chances of a recession next year.

The New York Fed projected in May that the central bank will shave $2.5 trillion off its holdings by 2025.

Estimates vary for how this will affect the economy: Orlando, at Federated Hermes, said every $1 trillion in Fed balance sheet reduction would equate to an additional 25 basis points in implicit rate hikes. Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, estimates it could add up to 75 basis points through the end of 2023 alone.

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On the other end, Solomon Tadesse, head of North American Quant Strategies at Societe Generale, believes the Fed will ultimately cut $3.9 trillion off its balance sheet, equating to about 450 basis points in implicit rate increases. The Fed has already raised rates by 225 basis points and another 75 basis point increase is expected later this month.

“It could be the ramp-up in QT that could trigger the next fall in markets,” wrote Tadesse, who believes the S&P could drop to a range of 2900-3200.

Investors next week will watch August consumer price data for signs inflation has peaked. The Fed will hold its monetary policy meeting on Sept. 21.

Jake Schurmeier, a portfolio manager at Harbor Capital Advisors, said reduced liquidity from tightening financial conditions is already making it more difficult to take large bond positions and will likely contribute to more volatility ahead.

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“It gives us pause before we make any moves,” he said. While Schurmeier finds longer-dated Treasuries attractive, he is “hesitant to add more risk until volatility has dampened down,” he said.

Timothy Braude, global head of OCIO at Goldman Sachs Asset Management, has been reducing his equity allocation in anticipation of more volatility due to the Fed’s quantitative tightening.

“It’s very hard to tell which markets are going to be the most affected,” he said.

To be sure, some investors doubt quantitative tightening will have an outsized effect on markets.

“The increase in the pace of QT has been known since the Fed announced its QT plans in May,” strategists at UBS Global Wealth Management wrote on Thursday. “However, when combined with a hawkish Fed, market sentiment focuses on the higher pace even though the impact to the marketplace over the long term is not material.”

The energy crisis in Europe, the pace and duration of the Fed’s interest rate hikes, and a potential U.S. recession are likely to trump quantitative tightening as market drivers, said David Bianco, chief investment officer, Americas, at the DWS Group.

“We’re not dismissing the risks of QT but they pale in comparison to the risks of where the Fed hikes the overnight rate and how long they have to stay there,” he said.

(Reporting by David Randall; Additional reporting by Ira Iosebashvili; Editing by Ira Iosebashvili and David Gregorio)