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Federal Reserve balance sheet reduction after so many years of expansion is like poking a hole in a hot air balloon that has reached high altitude – not a straightforward process. The last tightening went wrong for reasons that were wholly unexpected. Quantitative Tightening II might also go wrong.
What we can learn from history: Quantitative Tightening I went unexpectedly wrong
The Federal Reserve announced Quantitative Tightening I (QT1) in 2017, leaving the balance sheet reduction on autopilot so that 650bn dollars rolled-off the balance sheet. However, the market took this development poorly amid slowing economic growth as well as fears of a trade war with China. Market stress in early November 2018 mutated into an S&P500 tumbling by 16% in December. As a consequence, the Fed reacted as usual by putting a floor on the market – it abandoned rate hikes and announced the end of QT1 for March 2019.
What was even more unexpected was surging repo rates in September 2019 – that is the rates you pay to borrow bonds or equity. Overnight fixed income repo surged by as much as 10% intraday on the 17th of September. Too much leverage was looking for too few opportunities at too low a cost from the point of view of bank prime brokerages who lend primarily to hedge funds. This is one of the key mechanisms identified by the Bank for International Settlements (8 December 2019, September stress in dollar repo markets: passing or structural?). Hedge funds seem to have an borrowed enormous amount of capital to run absolute and relative trades in equity and fixed income to generate limited return. Another issue was that less liquidity was available because banks likely increased their purchases of longer dated bonds as the economy slowed.Faced with this, the risk management of one of the big four banks in the repo business (prime brokers) must have decided to reduce its risks given that the yield on such lending activity is low, collateral requirements moderate for what can be very large risks. Some hedge funds then probably found themselves struggling to find liquidity pushing short-term rates higher, forcing the Fed to inject massive amounts of liquidity.
The potentially unexpected effects of QT mean that the Federal Reserve should be more prudent this time around, as the Chairman said, “best to take a careful, methodical approach”. However, the January Fed meeting contained a shocking statement for the market: “Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”
Positioning for Quantitative Tightening II
We saw in January the impact of the expected monetary tightening on particularly long duration Growth stocks and this has started to ebb. The question now is what will happen when the reality of tighter liquidity slowly seeps into a market high on valuations many months from now. What we witnessed in January is a preview: 1. European equities have the advantage of decent growth ahead, far more reasonable valuations and a far more prudent central bank. Indeed, a rotation away from US Tech to European equities is a leitmotiv among sell-side analysts. 2. Flexible solutions with their counter-cyclical currency positions offer one of the few clear hedges against bouts of stress in US and global equity markets.
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