Another couple of days like Friday and we may not have to worry so much about the Fed finding itself in a situation where they need to conjure up another risk rally to rescue flailing markets and arrest surging volatility.
That said, things can turn on a dime and it’s worth noting (again) that according to the reporting on China’s “offer” to reduce the trade imbalance, the US delegation was “unimpressed”, where that means Trump’s negotiators wanted Beijing to cut the deficit to zero in two years versus the proposed six, an impossible ask.
Meanwhile, the burgeoning Trump-Pelosi feud bodes ill for a quick resolution to the shutdown and one question worth asking is what happens if all the delayed data releases end up betraying a further deceleration in the economy once they’re finally released. Presumably – and I’m just spitballing here – that would be a grievous blow to sentiment, especially if subsequent releases end up showing a drag from the shutdown.
The point is, we’re not out of the woods yet just because a couple of nebulous trade headlines managed to juice the YTD surge.
If, for argument’s sake, something goes “wrong” and we end up back in a spot where the Fed is forced to ponder how to help stabilize things, I would still argue that they’ll need to start tipping a change to the balance sheet plan. We’ve variously suggested that Powell has squeezed all the juice out of the “patient” rhetoric and simply reiterating that and underscoring the notion that more hikes are delayed until at least September likely won’t cut it (and there’s a policy pun in there).
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Damned If They Do, Damned If They Don’t: Fed May Be Boxed In On Balance Sheet
Of course we still don’t really know what the actual effect of balance sheet runoff is on equities. This is uncharted territory and after Q4 everyone is particularly keen on trying to project and otherwise quantify the impact of QT on stocks. We brought you some highlights from a Morgan Stanley note to that effect earlier this week.
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Ok, Sure! I’ll Take A Look At That Fed MBS Runoff Vs. S&P Returns Note…
One of the points we make continually when we discuss this is that on a conceptual level, the impact is straightforward. To wit, from that linked post:
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.
[…]
Perhaps the most useful thing about [any attempt to quantify the mechanical effect on stocks] 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.
This is a “top-down” liquidity withdrawal and the worry is that it’s conspiring with “bottom-up” liquidity concerns (e.g., diminished market depth) to create the types of adverse conditions that prevailed in Q4.
Well, JPMorgan’s Marko Kolanovic has some thoughts on this and as ever, his take is worth a look.
“Even passing remarks on the balance sheet can have visible and significantly negative intraday impacts on markets”, Marko wrote this week, before reminding you that he estimated “the impact of QE to be ~20% of equity prices based on causality tests.”
What about QT? Again, the worry is that in a market where bottom-up liquidity is severely impaired and the “flows-liquidity-volatility” feedback loop is in play, QT could end up having an outsized impact thanks to how fragile the market is.
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Marko Kolanovic Explains The ‘Liquidity-Volatility-Flows Feedback Loop’
“It is plausible that dollar for dollar, QT has a significantly larger impact than QE”, Kolanovic cautions, on the way to noting that “during QE, both central banks and investors more broadly buy assets in an environment of low volatility/increased liquidity when the impact is small, and during QT assets are typically sold while liquidity is removed, compounding the negative impact of other outflows.”
Clearly, Kolanovic thinks the real danger isn’t necessarily the actual mechanical impact (which nobody has yet quantified with sufficient veracity to make this or that study the “accepted standard”, as it were), but rather the collision of negative sentiment around balance sheet runoff with market fragility. To wit:
Whatever the real mechanical impact is, likely the impact on market sentiment is much larger (i.e., self-fulfilling impact). In support of that are recent intraday movements on balance sheet mentions, as well as the price action of the S&P 500 during Q4 shown in Figure 8. While there may be little or no mechanical impact on equity prices, most macro traders are not ‘fighting the Fed’ — when liquidity is added they are buying assets, and when liquidity is removed they are selling assets.
This is why it was so dangerous for Donald Trump to take to Twitter to lambast the Fed’s balance sheet rundown. It drew attention to something that most people had no idea even mattered.
That increase in public awareness likely exacerbated the negative market impact from the December Fed meeting and, especially from Powell’s presser. Balance sheet runoff was supposed to be “like watching paint dry”, but by tweeting out a reference to a high profile WSJ Op-Ed, Trump effectively turned “watching paint dry” into a national pastime.
Markets were thus more vulnerable to Powell’s “auto pilot” characterization and that vulnerability (read: predisposition to overreact by selling on any discussion of the balance sheet) collided with a dearth of liquidity last month.
On that note, we’ll leave you with one last quote from Kolanovic:
In this way, balance sheet reductions put significant strain on market sentiment, on flows and on the weakest link in the market — the liquidity-volatility-flow feedback loop. If the balance sheet reduction is a signal to sell, volatility increases, liquidity decreases, and additional systematic flows are triggered.
Patience for fundamentsls to finally get recognized and priced in will wear thin eventually (e.g., UST and eurodollar curve inversions getting corrected).