Markets tremble before an unprecedented double adjustment of the Fed

Markets tremble before an unprecedented double adjustment of the Fed

A quick double whammy of interest rate hikes and Fed balance sheet shrinkage risks destabilizing markets

For iProfesional

21/01/2022 – 07,46hs

A quick double whammy of interest rate hikes and the shrinking of the Fed’s balance sheet it risks destabilizing bond and equity markets that have already been hit hard.

The effects on the markets and economy of combine the two aspects of monetary tightening in rapid succession, something that has not been done before, and investors are transmitting their concern. The Nasdaq technology index fell more than 8% in the last 10 sessions trading, while Treasury bonds fell 2.3% this month, says the Bloomberg Agency.

Federal Reserve Chairman Jerome Powell and his colleagues would like to see some tightening of financial conditions to de-escalate the robust economy and help reduce the highest inflation in decades. A decline in asset prices after stocks and home prices hit records last year would help that process, as long as it didn’t turn into a destabilizing recession that wound up hurting the economy.

Markets tremble before an unprecedented double adjustment of the Fed

What complicates this task even more is that the Fed previously only reduced its bond reserve once, in 2017-2019, so it is difficult to try to calculate the impact of a larger and faster quantitative adjustment this time.

Markets tremble before an unprecedented double adjustment of the Fed

Markets tremble before an unprecedented double adjustment of the Fed

The president of the Federal Reserve Bank of New York, John Williams, expects long-term rates to “go up a bit” over time as the central bank reduces the size of its balance sheet. But acknowledged last week that it was “quite uncertain” thatHow big would be the impact of such a quantitative adjustment. “We have to be humble,” he told the Council on Foreign Relations on Friday.

One of his predecessors, William Dudley, expect the process to be smooth. Constant communication of the Fed’s plans will help, as will a liquidity support that the central bank put in place last year. The permanent tool of repurchase agreements, or repos, provides banks with an easy method of exchanging treasuries for cash, a safety valve that can help avoid the contraction seen in 2019.

How analysts see it

But nevertheless, Investors attribute far more “adjusting power” to balance sheet reductions than some Fed analysis, according to Deutsche Bank AG’s chief US economist Matthew Luzzetti, which increases the risk of unexpected settlements in risky assets.

While the operators increasingly price in a rate hike in March followed a few months later by the start of the Federal Reserve’s bond portfolio reduction, stock investors have become increasingly wary.

In 2017, the Fed began normalizing its balance sheet nearly two years after raising its policy rate in the short term from almost zero. And he reduced his bonus inventory in small steps. This time, the monetary authorities, including Powell, have made it clear that they will go faster.

The money experts noted that a different approach is warranted: the economy is stronger than it was then, inflation is much higher, and the balance sheet is much larger. In addition, the Fed holds $326bn of Treasury bills that could roll off the balance sheet in a matter of months if the proceeds are not reinvested.

While some pullback in risk assets could be helpful for the Fed, a major drop could damage the recovery. To avoid that, policymakers will likely prepare the market for what they intend to do, in Powell’s parlance, by socializing their intentions with investors, Bloomberg says.

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