The Fed may be nearing the end of its rate hikes, but plans to reduce its balance sheet still pose a significant risk to stocks.
The Federal Reserve has slashed its balance sheet by $900 billion over the past year and is showing no signs of stopping.
“Risk assets love liquidity. A continued drain on liquidity presents a risk to stocks,” Ned Davis Research said in a note on Thursday.
The Federal Reserve may be nearing the end of its rate hike campaign On the basis of the continued slowdown in inflation, But the central bank has another policy move that poses a huge risk to the stock market.
Since June 2022 The Federal Reserve slashed its balance sheet by $900 billion to $7.6 trillion, and it would have been more if the Federal Reserve had not had to inject $400 billion in liquidity into Containing the regional banking crisis in March.
As the Fed lowers its balance sheet by allowing Treasury and mortgage securities to mature (and then not reinvesting the proceeds), it takes liquidity from the markets.
“Liquidity is the lifeblood of financial markets,” said Joseph Kalisch, senior global macro analyst at Ned Davies Research. “Risk assets love liquidity. A continued drain on liquidity presents equity and credit risks.”
The Fed has been trimming its balance sheet by about $80 billion a month, and stocks tend to do well when exactly the opposite happens, according to an NDR report.
“Our analysis shows that when the 4-week change in reserves increased by more than $62 billion, equity returns exploded at an annualized rate of 31% since March 2009 when the Fed began ramping up quantitative easing and shifting to a buffer system,” Kalish explained.
“Conversely, when reserves have fallen by more than $38 billion over the past four weeks, stocks have suffered,” Kalish said.
That means stocks could get pressured even if the Fed pauses its rate-raising cycle for good later this year, as the central bank has shown no sign of halting its balance sheet reduction program. And the policy of reducing the balance sheet can have a significant impact not only on the stock market, but also on the economy.
“Reducing securities reduces banks’ reserves, which reduces banks’ liquidity and limits their ability to make loans and investments,” Kalish said.
That, together with sharp increases in interest rates over the past year, helps explain the tightening of credit conditions and the reduced willingness of banks to lend money. But whether the Fed’s continued tightening policies can undermine the stock market’s rally this year remains to be seen.
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