The time for the Fed to shrink its balance sheet is getting closer, and some believe that when the Fed withdraws hundreds of billions of dollars from the U.S. bond market, stocks may plummet, economic growth may slow and bonds may rebound.

Others believe that as the Fed pauses its rate hikes, inflation will fall, the economy will recover, and the stock market may resume its upward momentum.

Both scenarios are a bone of contention for investors as they prepare for the most aggressive monetary tightening in the U.S. in decades. The looming action includes so-called quantitative tightening (QT), which will see unprecedented liquidity in the U.S. financial system as the Fed stops reinvesting the proceeds of the $95 billion in U.S. Treasury and mortgage bonds maturing each month reduce.

In response, Fed policymakers said they were confident they could implement tightening without stifling the recovery. Goldman Sachs and JPMorgan also both see a U.S. recession unlikely, saying it’s too early to start looking away from stocks to government bonds.

On the other hand, Robeco, Brandywine Global and Citigroup see cutting risk assets and buying US Treasuries as a way to guard against the risk of stagnant growth. Among them, Citi is bearish on the stock market and believes that for every $1 trillion in liquidity the Fed reduces, the stock market will fall by 10%.

Goldman Sachs and Morgan Stanley are not worried about QT

Christian Mueller-Glissman, managing director of portfolio strategy and asset allocation at Goldman Sachs, said:

QT will add upward pressure on long-term bond yields, but the upward movement in yields is gradual as they are more tied to the overall size of the balance sheet than to changes in the balance sheet. Current real yield levels are unlikely to hurt economic growth or relative valuations. It’s too early to start switching from stocks to bonds. We remain overweight equities and underweight bonds. But we expect lower ROE going forward.

Goldman Sachs believes that the key question now is whether the rise in real yields will affect economic growth. Earnings season has been good so far, though, and the market doesn’t seem to be worried about it.

At the same time, Goldman Sachs does not see forward-looking recession risks rising significantly. The bank’s metrics put a 25% chance of recession risk in the next 12 months. Historically, you only need to worry about a big stock market drop if the indicator probability is higher than 40-50%.

Kelsey Berro, JPMorgan’s fixed income portfolio manager, is also more optimistic:

Currently, a recession is not our base case scenario and we will maintain our investment in investment grade and high yield credit. With the federal funds rate still near zero, the labor market is hot and the economy is running above potential, risky assets like credit are still worth investing in.

Morgan Stanley believes that the Fed has hinted at a short-term QT ​​policy. The bond market may have digested most of that. Over time, the direction of policy rates will be an important factor in driving yields and the shape of their curves.

Beware of Emerging Markets

Jane Foley, head of foreign exchange strategy at Rabobank, believes that the Fed’s QT may be moving faster than many investors expect, adding to the risk of policy-related market volatility and potentially increasing the chances of the Fed’s policy mistakes.

Foley said the shock from QT could ripple through emerging markets, where the cost of maintaining debt in hard currency could become an additional burden on top of higher food and oil prices. This could in turn widen the demand gap for assets between developed and non-commodity exporting emerging markets.

In this environment, the dollar could find some support from safe-haven demand, according to Foley. But markets have priced in a lot of Fed tightening, and Rabobank’s core view is that the dollar could be weaker than a basket of G10 currencies by the end of the year.

Bonds are better than stocks

Matt King, global market strategist at Citi, believes that the market is pricing in too much pessimism for long-term bonds while remaining too optimistic for equities:

As the Fed begins to tighten monetary policy and withdraw liquidity, we will return to the negative performance of risk assets that we saw earlier this year and last week. At this point, we are more pessimistic than the market consensus.

King shared a rule of thumb: about $1 trillion in QE or QT would cause stock prices to rise or fall by 10% over the next 12 months or so.

Bob Stoutjesdijk, portfolio manager at Robeco Institutional Asset Management, is more bullish on short-term Treasuries, arguing that the Fed will not be able to achieve a soft landing for the economy as they raise interest rates and withdraw liquidity through QT. The economy will slow down and enter a recession later this year. Stoutjesdijk stated:

Our positions are conservative, we are bullish on short-term government bonds, underweight credit and cyclical foreign exchange, and overweight swap spreads.

Stoutjesdijk noted that U.S. and U.K. two- and three-year Treasuries are accumulating in value because their yields have risen quite a bit, but he believes the Federal Reserve and other developed-market central banks will not be able to raise rates as quickly as the market expects. .

Brandywine Global portfolio manager Jack McIntyre is also buying Treasuries, saying:

We buy US Treasuries as a defensive strategy and trim risk assets. Because we expect economic growth to slow in the coming months and bonds to recover. The risk of stagflation is rising, but the market is now focusing more on the high-inflation component of stagflation. I suspect we will soon have to focus on the slowing part of economic activity in stagflation.

Jack McIntyr also said that the bank is concerned about the impact of the Fed’s dramatic reduction in liquidity and is not sure whether the Fed has fully grasped QE or QT. The Fed has been claiming that quantitative tightening will kick in on its own, and we should not worry . But the last time the Fed implemented QT, the stock market didn’t seem to be doing well .

This article is reprinted from: https://news.futunn.com/post/14936952?src=3&report_type=market&report_id=204197&futusource=news_headline_list
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