This ‘QE’ Is Different: Fed Balance Sheet Expansion Is Coming, But Nuance May Get Lost, McElligott Says

Despite the Fed having for now opted to go with a ‘Band-Aid’ approach to alleviating the funding squeeze that rippled across money markets earlier this week, driving the effective funds rate through the upper-end of the target range, Nomura’s Charlie McElligott said Thursday that in his view, “most in the market can see that Powell’s ‘balance sheet’ comments mean that permanent open market operations are an inevitability”.

The reference is to Powell’s press conference remarks in response to a question about whether the Fed had underestimated the amount of reserves necessary for the banking system.

“We’ve tried to assess [demand]”, Powell responded. “But yes, it’s certainly possible. We’ll be looking at this carefully in the coming days and taking it up at the next meeting”. “We may resume organic balance sheet growth earlier than originally thought”, he added.

Read more: Fed’s ‘Band-Aid’ Approach To Repo Chaos Opens Door To More Volatility, But Fear Likely Overblown

For McElligott, Powell’s comments suggest outright balance sheet expansion is “not far from realizing”, even as some market participants were disappointed the Fed chair didn’t address the funding stress more forcefully or with the proper urgency.

“Powell’s acknowledgement that the Fed may have to resume the ‘organic growth’ of its balance sheet sooner than expected… caught the Equities crowd flat-footed, ultimately helping rally S&P minis ~+35 handles off the pre-press conf lows”, Charlie notes, adding that traders “initially tried to press Shorts in Spooz on a ‘hawkish disappointment’ first-blush interpretation of the Fed”.

McElligott goes on to reiterate many of the main points he made on Wednesday, when he elaborated on the upside “risk” for stocks as market participants misinterpret balance sheet expansion to replenish depleted reserves as being akin to a new QE program.

He also notes that anyone lost in the throes of the factor unwinds and reversals that have characterized the “under-the-hood” equities action in September, was “NOT tuned in to the deeply macro $Funding drama” and therefore, the “idea of balance sheet expansion was something thought to be FAR down the road –a ‘break glass in case of emergency’ option for when a Recession hits”.

Now that balance sheet expansion is all but a foregone conclusion, the door is open for the “muscle memory” McElligott discussed previously to catalyze a “near-term bullish overshoot” potentially turbocharged by a reversal of the usual down-out-of-Op-Ex  seasonality in September. There’s more on that in the linked “muscle memory” post, but here’s the quick version from Charlie’s Thursday note:

Instead, the balance-sheet discussion is suddenly a “NOW” thing–and in the post-GFC regime, the muscle memory of investors has conditioned them to simply think “balance sheet expansion = QE” and risks a “BULLISH risk-asset sentiment shock,” ESPECIALLY with 60% of the current $8.3B $Gamma at the 3000 strike about to come-off following Friday’s Op-Ex and with large $Gamma above all the way up to 3100.

Looking ahead, the Fed’s messaging around balance sheet expansion will be crucial in terms of shaping market participants’ perception.

“What matters most to markets is the ability for the Fed to shed further light onto the nature of Powell’s balance sheet commentary”, Charlie goes on to say, adding that “many market participants misinterpret this to mean ‘outright QE’ as opposed to something far more nuanced”.