While many investors may see inflation as the biggest threat to their holdings, some are more worried about the possibility of the Fed exiting bonds, portends an article in The Wall Street Journal. That tightening move would drain liquidity out of the markets at the same time that increasing interest rates and declining share prices would need more cash to soften the fall.
The central bank has quickened its bond runoff, with the goal of reducing its mortgage-backed securities by $35 billion and Treasury holdings by $60 billion per month. That could create a “liquidity hole,” many managers believe, including those from London-based Ruffer LLC and the hedge fund Bridgewater, the article reports. And while Savita Subramanian of Bank of America predicted that quantitative tightening (QT) by itself could result in a 7% price drop when the bump received from quantitative easing (QE) is reversed, Steven Major of HSBC said that the relationship between QT and the economic system was too complicated to warrant any real predictions.
But QT is different now than it has been in the past, given the large amounts of reserves that have flowed through money-market funds back into the Fed. Those funds have drained $2.2 trillion out of the reserves since the start of last year and while that’s currently not an issue, it could affect whether banks are willing to take risks and cause managers to withdraw funds to cover their losses. Some strategists have even voiced the dire concern that banks’ reserve levels will hit the minimum that the Fed needs; Tim Wessel of Deutsche Bank said in a recent note that when the banks hit the $2.5 trillion reserve mark, the Fed should stop tightening, and predicted that moment could come as early as January 2023 if money-market funds continue to withdraw. However, a quicker end to QT would also mean the Fed would need to push rates still higher.
While these risks are legitimate, the question remains whether or not they will actually come to pass, the article contends—and there are plenty of other issues, such as the market being ill-prepared to handle weaker earnings in 2023, to keep investors bearish.