Over the weekend, we spent quite a bit of time talking about the Fed’s balance sheet and the extent to which Powell’s dovish relent on the rate path (as reinforced by multiple Fed officials and also by the December minutes) may mean that the only “escape valve” going forward will be to halt or tweak the pace of runoff if market volatility comes calling again.
Long story short, the mammoth rally in risk assets off the December 26 overnight lows appears to be predicated entirely on the assumption that another hike in H1 is now out of the question which means simply reiterating that point in the event stocks start falling again and/or credit spreads balloon wider won’t likely be “enough”.
Of course there are a variety of “accelerants” (if you will) that helped buoy risk assets once things got going in the right direction again. You can, for instance, point to short-covering (which may just be getting started if you look, for example, at short interest on SPY) and a dearth of HY supply, with the latter helping to turbocharge the junk rally along with surging crude prices.
But the bottom line is that the real spark came from Jerome Powell’s comments in Atlanta two Fridays ago and his message was underscored (and then some) last week.
Now, Powell and his compatriots might have squeezed all they can squeeze out of a dovish relent on rates and the irony is that if the rally runs too far, too fast, the market may start to get the idea that further hikes are back in play. That could then tank markets anew, leaving the Fed right back in the position they were in last month. This time around, however, simply reiterating “patient” may not be enough. Here’s how we put it over the weekend:
Now sure, a continuation of that kind of action could ironically put March and/or June back in play (as it would loosen financial conditions materially, especially if paired with further dollar weakness), and that leads directly to the crux of the problem. Let’s say we run too far, too fast leading the rates market to start pricing in hikes again while trade talks falter and the drama inside the Beltway continues. If the selloff were to resume and credit were to start widening out again, it’s hard to imagine how the Fed could engineer another rally just by repeating what they said last week. Rather, they would likely have to start talking about the balance sheet, only in more concrete terms. They gave the market an inch and now it wants a mile.
JPMorgan underscores that in a note dated Friday. “As short covering continues and equity markets recover, there is a chance that the Fed makes a u-turn and becomes hawkish again”, the bank warns, adding that “this could indeed be a major risk for equity markets into Q2.”
That, in turn, means that in order to re-engineer a rally, the Fed would need to first try to convince the market to take hikes back off the table and if that doesn’t work, start talking about the balance sheet.
Needless to say, the effect of balance sheet rundown on stocks is the subject of considerable debate. We talked at length about that on Saturday and we’ve been over it more times than we care to remember since 2017. Conceptually, this is pretty simply. When the Fed pulls the price insensitive bid at a time when Steve Mnuchin is increasing supply (to fund the tax cuts), the supply/demand dynamic for safe haven Treasurys changes materially and the onus falls on the market to absorb more net supply. That, in turn, saps demand for risky assets or, more simply, sucks liquidity out of the market.
“The Fed’s balance sheet shrinkage together with the increased federal budget deficit is raising the supply of US government-related bonds, inducing fixed income investors to shift their investments away from US corporate bonds towards US government bonds, effectively reversing the big credit overweights built up when the Fed was expanding its balance sheet”, JPMorgan reminds you, in the same note cited above, on the way to reiterating that “during the QE years, these non-bank investors increased significantly their corporate bond holdings as central banks were absorbing government related bonds, thus becoming increasingly overweight credit.”
Right. Of course “increasingly overweight credit” drove spreads “increasingly” tighter and thereby pushed investors further down the quality ladder and further out the risk curve into junk and, ultimately, into equities. That’s all by design and now it’s reversing.
So that’s the narrative. As far as the mechanical impact is concerned, Morgan Stanley’s quants are out with a note that seeks to quantify the actual impact on stocks of balance sheet runoff.
“Since 2009, the S&P 500 has had a statistically significant 0.37% sensitivity to MBS balance sheet changes”, the bank writes, before breaking things down and noting that “8 of 11 sectors also have significant positive sensitivities to Fed MBS holdings changes, and 10 of 11 sectors have positive sensitivities.”
Here’s the chart on that (what you want to bear in mind is that, as the bank explains, “a positive sensitivity means that the expected equity return is positive when the balance sheet expands and negative when the balance sheet contracts”):
Ok, so cutting through the tedious details, what the bank finds is that it’s better to look at the long-run sensitivities (as opposed to just the normalization period) if what you want are meaningful numbers and that when it comes to what matters for stocks, it’s not Treasury runoff that counts, but MBS.
On that latter point, the explanation is pretty intuitive – as these things go, anyway. Here’s Morgan (trying) to explain:
The mechanism through which quantitative easing (tightening) is generally believed to work is portfolio rebalancing: a certain asset class becomes less risky through Fed purchases and investors reallocate to other assets to maintain the risk level in their overall portfolio. It appears that the portfolio rebalancing link is stronger between equities and MBS than between equities and Treasuries. The correlations with sector returns are supportive of this conclusion. Real estate and cyclical industries are the most correlated with MBS changes, whereas defensive sectors – particularly staples, but also health care and utilities – are most correlated (though not significantly correlated) with Treasury changes. It makes sense that defensive sectors, generally with higher yields, should be better substitutes for Treasuries than other sectors.
MBS holdings are dependent on both maturity and pre-payment, which makes their trajectory somewhat more difficult to estimate than that of Treasuries, which depend only on securities maturing. Consequently, investors pay closer attention to innovations in MBS holdings than to changes in Treasury holdings.
So, what’s the takeaway? That is, if we just cut to the chase, how much impact can we expect for equities in 2019 given the current run rate of MBS runoff?
According to Morgan, the answer is just over -3%. That’s based on an assumed $180 billion total MBS reduction over the year. Here is the sector-by-sector breakdown.
The next natural question is whether a presumed tweak to the balance sheet normalization plan would ameliorate this situation and according to the bank, the answer is probably not.
Morgan assumes balance sheet normalization will come to halt in September, but the mechanics will be such that “the MBS runoff continues, but the proceeds from MBS are used to buy Treasuries and the overall level of Treasuries is maintained.” Well, if you followed the analysis above, you know that won’t help – at least not for stocks, because equities appear to be sensitive to MBS not Treasurys.
Should you take this to heart? Maybe. Or maybe not. Yes, this emanates from the bank’s quants and yes, they are PhDs, but this is an inherently imprecise endeavor. Clearly, there are all manner of factors that help to explain how equities have behaved over the last decade and while I’m absolutely sure that Morgan attempted to control for as much of that variation as possible and while the effort here is to be applauded, it should be viewed for what it is: a series of estimates and projections which, while based on math, cannot possibly capture the myriad embedded contingencies, especially on a forward-looking basis.
Perhaps the most useful thing about this analysis is the extent to which it’s incremental to the common sense-based assessment outlined above which, in its simplest form, simply says that balance sheet runoff amounts to tightening and that being the case, it will naturally serve to exacerbate market volatility emanating from a generalized souring of sentiment, diminished liquidity and/or exogenous shocks.
And, that’s it. I’m done with this one.