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Wall Street Pundits Rewrite Playbook as Fed Reverses Years of QE

© Bloomberg. A sign for Wall Street and American flags in New York, U.S.. Photographer: Bloomberg Creative Photos/Bloomberg

(Bloomberg) — When the Federal Reserve starts pulling hundreds of billions of dollars out of the American bond market later this year, stocks will tumble, growth will weaken and bonds will rally back from their worst losses on record.

That’s one scenario. Here’s another: equities resume their ascent as the Fed pauses its interest-rate hike campaign, with inflation receding and the economic recovery intact.

Which case is most likely is at the heart of a debate among investors bracing for the most aggressive U.S. monetary tightening in decades. The campaign is soon set to include so-called quantitative tightening, with an unprecedented pullback in cash from the financial system as the Fed stops reinvesting the proceeds from as much as $95 billion of its Treasuries and mortgage bonds that mature each month.

Fed policy makers have expressed confidence they can execute their tightening without killing off the recovery. Goldman Sachs Group Inc (NYSE:GS). and J.P. Morgan Asset Management are among those who agree that a recession is unlikely, and say it’s too soon to start shifting from stocks into government bonds.

Among those in the other camp: Robeco Institutional Asset Management, Brandywine Global Investment Management and Citigroup Inc (NYSE:C). To them, cutting back on risk assets and buying government bonds is a way to protect against the risk that growth will stall. 

Citigroup is bearish on stocks, calculating that every $1 trillion in liquidity reduction by the Fed equates to a 10% fall in stocks. 

The following is a selection of further perspectives on the implications of Fed quantitative tightening — set to be announced as soon as May 4. Quotes have been edited for length and clarity.

Stay in Stocks

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

QT will add to upward pressure on longer-dated bond yields. But increases should be gradual as they are more linked to the overall size of the balance sheet rather than changes. Real yields at current levels are unlikely to hurt growth or relative valuation. 

It’s too early to start shifting away from stocks into bonds. We remain overweight stocks and underweight duration. That said, we expect lower returns from equity.

The key question now is whether rising real yields are going to hit growth. As of now, with the earning season being decent, markets seem to have shifted away from that concern. 

Right now, we are not having a huge pick-up in our forward-looking recession-risk indicator. Our indicator shows a 25% probability of recession risk over the next 12 months. Historically, probability above 40-50% are levels at which one should be worried about a sharp equity drawdown. We are not quite there yet. For sentiment to shift markedly bearish, we need much higher recession probability than now.

Beware Emerging Markets

Jane Foley, head of FX strategy, Rabobank:

A faster pace of QT than perhaps many investors had been prepared for raises the risk of increased market volatility associated with the policy, and possibly also the chances of a policy mistake.

Shockwaves of this policy are likely to travel through emerging markets, where the costs of maintaining debts in hard currencies could become an extra burden on top of higher food and oil prices. This in turn could broaden a gap between demand for assets of developed countries and those of non-commodity exporting emerging markets. 

The U.S. dollar could see some safe-haven support in this environment. However, with so much Fed tightening priced into the market, it is our central view that the dollar is likely to concede some ground to a basket of G-10 currencies into the end of the year.

Bonds Over Equities

Matt King, global markets strategist, Citigroup:

Market pricing is too bearish on long bonds and still too optimistic on equities.

As the Fed embarks on the tightening and actually withdraws liquidity, we will go back to the same negative performance on risk assets that we saw earlier this year and last week. And on that, we are more pessimistic than consensus. A useful rule of thumb is roughly a $1 trillion dollars of QE or QT is worth about 10% on the equity market over the course of the next 12 months or so. 

Still Liking Credit

Kelsey Berro, fixed-income portfolio manager, JPMorgan (NYSE:JPM) Asset Management:

For now, recession is not currently our base case, and we maintain investments in investment-grade and high-yield credits. With the fed funds rate still close to zero, the labor market red hot and the economy operating above potential, risk assets like credit should still find sponsorship.

The Fed has telegraphed the QT strategy in the near term. From that perspective the bond market has likely priced much of the announcement.

Over time, the bigger driver for yields and the shape of the Treasury curve will ultimately be the path of the policy rate.

Short-Term Government Debt

Bob Stoutjesdijk, portfolio manager, Robeco Institutional Asset Management:

The Fed won’t be able to achieve an economic soft landing as they raise interest rates and withdraw liquidity through QT. The economy will slow down later this year, heading into a recession.

Our positioning is conservative, we favor short-maturity government bonds, are underweight credit and cyclical FX while being overweight swap spreads.

We like government bonds, but keep duration conservative. There is value building in two- and three-year government debt of the U.S. and the U.K., because their yields have come a long way, and we don’t think the Fed and other developed-market central banks will be able to hike interest rates at the pace that the market has priced in. Similar opportunities are building in Canada, New Zealand, and Australia.

Buying Treasuries

Jack McIntyre, portfolio manager, Brandywine Global Investment Management:

We are buying Treasuries as a defensive play and paring back on risk assets because we expect growth to slow down and bonds to recover in the next few months. Risk of stagflation is rising, but the market is currently focusing more on the high inflation component of it. I suspect that soon we will have to focus on the slowing economic activity part of stagflation.

We are going to have a massive reduction in liquidity and I’m worried a bit about that. I’m not sure if the Fed has a total grasp on QE or QT. They keep telling us it’s going to be on an auto-pilot and we should not be worried. But the last time they did QT, the equity market didn’t seem to like it at all. 

©2022 Bloomberg L.P.

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