‘The Thrill Is Gone’ For Equities. And Your QT Questions Answered

For the better part of a dozen years, stocks were beyond reproach.

Thanks to subdued inflation across the developed world, the Fed had more than enough plausible deniability to persist in a growth-conscious policy bent, which meant, among other things, everywhere and always citing the threat of disinflation as an excuse to lean incrementally dovish at the first sign of trouble.

Decelerating economic momentum was an excuse. Below-target inflation was an excuse. And, crucially, falling stocks were an excuse too. Although policymakers were loath to admit publicly to the existence of the so-called “Fed put,” stocks in free fall represent a reverse wealth effect, which could curtail consumer spending. As such, selloffs that threatened to go beyond 20% were generally met with conciliatory rhetoric from officials.

In 2022, after one final parabolic rise catalyzed by the most lavish Fed policy in history, stocks went from sacred cow to sacrificial lamb. The US labor market will likely be even slower to respond to waning growth momentum than usual given a still acute labor shortage, and the combination of extremely elevated wage growth and a likely moderation in gas and food prices could mean consumer spending remains resilient, despite the Fed’s efforts to cool it. That leaves equities.

Having successfully chipped away at the foundations of the pandemic housing bubble, the Fed is likely to lean against stock prices, especially if they look poised to run higher, as they did over the summer. The S&P is currently riding its longest losing streak since June (simple figure above).

As a reminder that no one needs, seasonality isn’t your friend. September isn’t typically kind to stocks. The S&P has lost an average 1.25% during the month going back nearly a century. Throw in an accelerated pace of QT, a lockdown in China’s sixth-largest city and the prospect of more tumult across the European energy complex, and you’re left to ponder a noxious mix.

Unfortunately, there’s no backstop. “Equities trade ‘without a net’ and bearishness / shorts are re-emboldened, because the perception is that at least for the next few months, there’s no Fed pivot cavalry coming to the rescue,” Nomura’s Charlie McElligott said, noting that the bank’s multi-factor S&P sentiment index came into September back near pre-summer rally lows (figures below).

“The thrill is gone,” McElligott continued. A backtest of the gauge for scores below the August 31 level suggests “no bounce” in the near-term and negative excess returns going forward.

There are three additional factors that have bears smelling blood, McElligott said. The first is the familiar notion that the profit “reckoning” which was kicked down the road during Q2 reporting season will be “live” again soon. Relatedly, corporates will enter buyback blackouts as Q3 earnings approach, removing a source of plunge protection.

And then there’s QT escalation, which markets may be “particularly sensitive” to, Charlie wrote, recalling the 2018 experience, when, “along with a number of idiosyncratic factors, cross-asset market volatility explode[d] higher with rate hikes and liquidity being removed, effectively requiring price discovery again in US Treasury and mortgage markets, which needed to find a ‘clearing price’ for private investors, as the Fed no longer [served as] the backstop-buyer.” That, he cautioned, could set the stage for more volatility in rates.

There’s quite a bit of confusion out there about the mechanics and technicalities of runoff. The excerpted passes (below, from Goldman’s Praveen Korapaty and TD’s Priya Misra and Gennadiy Goldberg, respectively) should clear up most common questions.

The Fed’s runoff caps are set to double to their announced peak of $60 billion USTs and $35 billion MBS per month this month. The first three months of runoff has seen the SOMA portfolio shrink just $74 billion, somewhat less than the potential $142.5 billion of runoff that the initial caps could have allowed for. There are technical reasons for this apparent discrepancy. The first is the long lag time between MBS purchases and settlements; these only show up as a factor supplying reserve balances when settlement occurs, up until which they are a “commitment to buy.” At the start of June, the Fed had nearly $60 billion in net commitments to buy MBS due to prior purchases that had not yet settled, and since then, this has dropped significantly, with the sum of MBS held outright and net commitments down $42 billion over the same period. The second is that, on the Treasury side, inflation accrual on the Fed’s TIPS holdings has offset some of the impact from maturities being allowed to roll off. With the higher caps, near-term slowing of inflation accrual and a reduction in unsettled MBS purchases should mean both of these factors are less of a drag on runoff in the months ahead. — Praveen Korapaty, Goldman

QT will ramp up starting in September, with the Fed allowing up to $60 billion in Treasurys and $35 billion in MBS to run off the balance sheet each month. Note that while average monthly runoff will likely be below the total $95 billion per month cap due to slower MBS prepays, it will be notably faster than the combined $50 billion peak runoff pace in 2018-2019. Treasury is using its $326 billion bill portfolio to make up any shortfalls in the monthly $60 billion Treasury runoff cap. Thus, we expect the Fed’s balance sheet to decline significantly in coming months, decreasing from a peak of $8.9 trillion before runoff started to $8.5 trillion by the end of 2022 and falling just below $8 trillion by mid-2023. Given Treasury coupon maturities of $44.6 billion in September, Treasury will allow $16.4 billion of bills to run off. In November, the $60 billion Treasury cap will be binding and no bills will runoff. MBS runoff has remained significantly lower due to slow prepay speeds as mortgage rates have risen sharply. We estimate that prepays will average around $22 billion in September, $21 billion per month for the remainder of 2022 and approximately $20 billion per month in 2023. While MBS runoff is likely to remain well below the Fed’s $35 billion cap, we don’t expect the Fed to actively sell MBS as housing market activity has already slowed sharply in recent months. In addition, Fed MBS holdings are long duration in nature, and selling would have a disproportionate impact on longer term rates. — Priya Misra and Gennadiy Goldberg, TD