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(Bloomberg) — A quick boost of interest rate hikes and balance sheet reduction from the Federal Reserve is likely to disrupt bond and equity markets that have already been battered.

The effects on markets and the economy of combining the two sides of monetary tightening in quick succession – something it has never done before – are unknown, and investors are telegraphing their concern. The Nasdaq Composite Index has slid more than 8% in the past 10 trading sessions, while Treasuries are down about 1.8% this month.

“The scale of what they’re looking at now is completely unprecedented,” said Janice Eberly, a former Treasury Department official now at Northwestern University. “It’s prudent to gauge market reaction, especially before moving the balance sheet in concert with interest rate changes.”

Fed Chairman Jerome Powell and his colleagues would like to see a tightening of financial conditions to dampen the robustness of the economy a little and help bring down inflation, which has reached decades. A pullback in asset prices after stock and house prices hit record highs last year would help this process, as long as it doesn’t turn into a destabilizing slump that ultimately hurts the economy.

Make this task trickier: The Fed has only cut its bond stock once before, in 2017-19, so there’s not much to try to calculate the impact of deeper and faster quantitative tightening this time around.

New York Federal Reserve Chairman John Williams expects long-term rates to “rise somewhat” over time as the central bank shrinks its balance sheet. But he admitted last week that he was “quite uncertain” of the extent of the impact of such quantitative tightening. “We have to be humble,” he told the Council on Foreign Relations on Friday.

Safety valve

One of his predecessors, William Dudley, expects the process to go smoothly. Regular communication of the Fed’s plans will help, as will a backstop the central bank put in place last year. The standing repo facility, as it is called, offers banks a simple method of exchanging treasury bills for cash – a safety valve that can help avoid the squeeze seen in 2019.

Don’t panic about the Fed’s big balance sheet: Bill Dudley

Still, investors are attributing far more “tightening power” to balance sheet cuts than some Fed analyses, according to Deutsche Bank AG’s chief U.S. economist Matthew Luzzetti, raising the risk of unexpected asset sales. risky assets.

As traders increasingly expect a March takeoff for rate hikes followed within months by the start of the Fed’s reduction in its bond portfolio, equity investors have grown increasingly wary.

In 2017, the Fed began to normalize its balance sheet nearly two years after raising its short-term policy rate from near zero. And he reduced his bond inventory in small steps, starting the monthly trickle at $10 billion and slowly and steadily growing to $50 billion a year later.

Policymakers, including Powell, have made it clear they will go faster this time.

Monetary experts said a different approach was warranted: the economy is stronger than it was then, inflation is much higher and the balance sheet is much larger. Additionally, the Fed holds $326 billion in Treasuries that could roll off the balance sheet within months if the proceeds are not reinvested.

What Bloomberg Economics says…

By the middle of the year, we expect the FOMC to recognize that it still needs to do more to give the best chance of finally hitting its 2% target. As a result, the committee will likely increase fivefold this year. We currently expect the balance sheet run-off to begin in the third quarter of 2022, with a huge margin of uncertainty around that time.

— Anna Wong, Chief U.S. Economist

For the full note, click here

While some pullback in risk assets could help the Fed, a major dip could hurt the recovery. To avoid this, policymakers would likely prepare the public for what they intend to do, by – in Powell’s parlance – communicating their intentions with investors.

They may have a long way to go to get there.

Speaking to reporters on Jan. 13 after a meeting of the American Bankers Association’s economic advisory board, Morgan Stanley’s U.S. chief economist Ellen Zentner said the group was broadly on board for the pullback to begin. in the middle of the year. But there was a wide range of views on how quickly it would unfold.

Zentner, for its part, expects an announcement in July of an initial monthly balance sheet reduction of $40 billion, rapidly rising to $80 billion in September. That would be on top of the four-quarters of a percentage point Fed rate hike it expects this year.

Weighing QT

To complicate the outlook: some policymakers have described quantitative tightening as a potential substitute for some rate hikes, just as quantitative easing was for rate cuts.

Brian Sack, director of global economics at the DE Shaw Group, estimates that it would take about $600 billion of balance sheet contraction to come close to a quarter-point rate hike. That compares to the $300 billion estimate he and Joseph Gagnon made in a 2018 paper for the Peterson Institute for International Economics.

The change is because the Fed has deployed far more QE during the pandemic and longer-term yields are lower and less volatile than in the past. Sack also cited “evidence that rates have been quite resilient to changes in Treasury supply.”

“The economy is strong enough that the Fed probably needs to raise the fed funds rate significantly, even if it shrinks its balance sheet,” added Sack, a former Fed official.

Michael Gapen, chief US economist at Barclays Plc, points to the large amount of cash parked in the Fed’s reverse repo facility – nearly $1.6 trillion – as evidence that the Fed can easily QT more aggressive.

Yield curve

Some politicians prefer to rely more on quantitative tightening than in the past. One argument in favor of this approach: it could help limit a flattening of the yield curve which pinches banks’ credit margins and therefore affects their willingness to provide credit to the economy.

A rapid reduction in the Fed’s bond portfolio could drive longer-term yields higher as policymakers raise the benchmark short-term rate. This could preserve lenders’ margins, supporting the flow of credit. But a spike in rates across the curve could also hurt equities, undermining business confidence.

Powell said this month plans to cut the bond portfolio will be discussed at upcoming policy meetings.

Ultimately, the economic effects of a balance sheet reduction are highly uncertain, said former Bank of England policymaker Kristin Forbes. It could be like “paint drying in the background” or could have a bigger impact, especially if markets aren’t prepared, she said.

“Any move in this direction must be made with extreme caution, as you will have to feel the pinch as any unwinding of the balance sheet unfolds,” said Forbes, who currently works at the Massachusetts Institute of Technology.

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