If you were watching every tick during Jerome Powell’s press conference on Wednesday, you’d be forgiven for thinking that market participants are at least as concerned about the Fed’s steadfast refusal to countenance tweaks to the balance sheet runoff plan as they are about rate hikes.
A simple look at the S&P as Powell spoke shows the selling accelerated when the balance sheet came up and to be clear, part of that is likely due to the fact that Trump brought the issue to the public’s attention prior to the Fed meeting, thus heightening concerns.
That said, Trump is late to this party. People whose brains are much “larger” than Trump’s and whose “guts” actually are reasonably reliable, have variously warned that the Fed should calibrate the pace of balance sheet runoff to take account of the “tremendous” (to use a Trump-ism) uptick in Treasury supply necessitated by the President’s fiscal policies.
This isn’t complicated. The greater the burden placed on the market in terms of absorbing a larger net supply of U.S. debt, the less liquidity available for risky assets. It’s a “crowding out” effect and when considered in conjunction with rising rates on USD “cash”, the read-through for other assets is profound.
Well, in a note dated Friday, Goldman writes that while “Fed balance sheet runoff may indeed have contributed to some extent to the recent decline in risk appetite”, they are reluctant to “assign to it a central role in explaining the bearish market trends in 2018H2.”
The real culprits, the bank says, are decelerating global growth and the above-mentioned allure of rising rates on short-term USD debt or, more to the point, the appeal of “cash” as an investable asset.
To support this relatively benign take on balance sheet runoff, Goldman simply cites price action in MBS and Treasurys.
“If Federal Reserve balance sheet normalization was the major driver of the 2018 bear market, we would logically expect to see agency mortgage backed securities and Treasury bonds experience out-sized price declines, as these are the assets most directly affected by the runoff”, the bank writes, before explaining that “agency MBS excess returns under-performed vs. IG corporate bonds on the year, but only to a modest extent, and agency MBS excess returns in 2018 have been roughly in line with their usual relationship to equity returns.”
On Treasurys, Goldman flags the bleeding term premium and an inverted real yield curve. “If Treasury bonds were cheapening because of runoff of the bonds from the Fed’s portfolio, we would expect widening in the term premium component of Treasury yields, as occurred in 2013 during the taper tantrum episode”, the bank says, before reiterating the obvious, which is that the term premium remains suppressed.
Finally, Goldman leans on what one might fairly describe as a “common sense” approach to this issue, noting that “the magnitude of the Fed’s balance sheet runoff – $330bn in face value to date between mortgages and Treasuries – does not seem large enough to explain recent asset price movements, given that the NYSE alone has lost $3.3tn in market value in recent months.”
Duly noted. And that speaks to the contention that there are other factors at play which help to explain equity volatility and a lack of liquidity. Top-down liquidity concerns (emanating from a withdrawal of central bank accommodation) are exacerbated by bottom-up issues (as manifested in low bid/ask depth and diminished top-of-book depth). Additionally, increasingly erratic domestic and foreign policy emanating from the Oval Office makes things immeasurably worse for risk assets, and contributes to the “sell the rips” mentality that supplanted “buy the dip” in 2018.
Still, it’s certainly no coincidence that “buy-the-dip” stopped working just as QE morphed into QT, an epochal shift that’s now colliding with the ongoing decline in the Chinese credit impulse.