Good morning. Tuesday was a tense day for stocks.Microsoft, selling a huge game Dealing with Activision Blizzard, sagging. Yields returned to near pre-pandemic levels. The Fed is scaring people.

But the Fed has many scary ways to do it—by raising interest rates, or by shrinking its massive balance sheet. Today we look at a second source of fear.

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Normalization is not much normal

In hindsight, I suspect that, from a market perspective, the most important paragraph from the Fed’s December minutes might have been this one:

Nearly all participants agreed that it might be appropriate to begin shrinking the balance sheet at some point after the target range for the federal funds rate was first raised. However, compared with the Committee’s previous experience, participants judged that the appropriate timing for a balance sheet reduction may be closer to the timing of a policy rate hike. They noted that current conditions include a stronger economic outlook, higher inflation and a larger balance sheet, so the pace of normalizing policy rates may need to be accelerated.

That said: The FOMC thinks it might make sense for the Fed’s balance sheet to shrink relatively quickly after the start of rate hikes. Why is this so important? How the balance sheet runoff will affect the economy and markets is uncertain, but there are reasons to think the impact could be significant. The Fed itself has acknowledged the uncertainty. Another paragraph in the minutes mentions that the committee agreed (emphasis mine):

Adjusting the target range for the federal funds rate should be the Committee’s primary means of adjusting the stance of monetary policy. . . this preference reflects the view that There is less uncertainty about the impact of changes in the federal funds rate on the economy than the impact of changes in the Fed’s balance sheet.

So what, if anything, do we know about the impact of shrinking balance sheets? Ironically, we probably know very little about its impact on U.S. Treasury yields, and perhaps less about its impact on other risky assets like stocks and corporate bonds.

a basic point. Balance sheet runoff is different from a contraction in asset purchases on the one hand, and direct quantitative tightening or bond sales to the market on the other. The tapering slowed and eventually ended the expansion of the Fed’s balance sheet. After the tapering is complete, the Fed still maintains the size of its balance sheet by rolling over maturing bonds to buy new ones.It buys these assets from the Treasury at prices determined by public auctions (the Fed itself does not participate in the auction; the allocation to the Fed is “Add on” auction). But the Fed can reduce the amount of maturing bonds it rolls over at a certain point in time and at a certain rate.

When the bonds held by the Fed mature, the central bank withdraws the principal from the Treasury in the form of reserves and then disappears at the touch of a keyboard. The reserves the Fed created to buy bonds in the first place simply no longer exists.This sparked a series of other deals (read Joseph Wang’s excellent generalize on the Fed Guy blog).

In short, the key fact is that the Treasury still needs to fund government operations. Treasuries that were once bought by the Fed must be owned by another investor. This investor buys bonds with cash, and the cash ends up flowing into the Fed through bank intermediaries in the form of reserves, which (as we say) then disappear. Investors used to have cash and now have coffers; the Treasury still owes money, but to investors not the Fed; the Fed has a smaller balance sheet.

What does this mean for the market? Jim Caron, chief fixed-income strategist at Morgan Stanley Investment Management, put it bluntly that the role of Fed bond purchases is to limit the supply of long-term risk-free assets. This makes interest rates on these assets lower than they would otherwise be. Shrinking the Fed’s balance sheet would have the opposite effect, pushing up interest rates. Pushing long-term rates higher in this way would allow the central bank to raise short-term rates without inverting the yield curve, which would spook everyone.

How much will the Fed shrink its balance sheet? According to Caron, until risk markets start screaming — especially until credit spreads start to widen significantly. What level of 10-year yield would make this happen? Two percent? Hard to say. Whatever it is, Caron said the question for investors is whether this level is the peak of interest rates and therefore a buying opportunity. We just don’t know the answer:

We can, in biblical parlance, “beware of false prophets”—beware of those who know how tightening balance sheets will work.

This may sound like fidgeting, but remember the quote above: the Fed itself has expressed similar uncertainty.

The last time the Fed started shrinking its balance sheet was in late 2017, and 2018 was a rough year for stocks:

But, as Caron pointed out, this is just one data point.

Robert Tipp, head of global bonds at PGIM Fixed Income, believes that historically, once the Fed begins to shrink its balance sheet, the market has largely anticipated the impact, rates have almost peaked, and it’s time to buy U.S. Treasuries are up. Here’s the Fed’s balance sheet, 10-year Treasury yields, and the Fed’s policy rate:

By the time the runoff began in early 2018, U.S. Treasury bond rates had been near highs, falling sharply by the end of the year. But what happens to risky assets as interest rates fall? They face significant headwinds because of changes in investor portfolios due to balance sheet runoff, Tipp said. “Others have to use their balance sheets to buy these Treasuries and mortgages. Are they going to reduce the risk of buying them?”

Ian Lyngen, head of rates strategy at BMO Capital Markets, agrees. “If there is an impact on interest rates, it will be fleeting at best,” he said of balance sheet runoff:

The Fed may have thought that by shrinking its balance sheet in 2017-2019, the curve would have become steeper, but it has flattened during that period — suggesting there is no one-to-one relationship with the shape of the balance sheet. The direct leverage of the curve or long-term interest rates to the size of the balance sheet.

Like Tip, he thinks the liquidity effects of runoff could hit risk assets:

Consider what the Fed has done with quantitative easing.It is designed to push investors out of the yield curve in search of yield, and once it does, it pushes them out of the credit curve and then the corporate structure curve[to equities]. . . What happens when this reverses?

It stands to reason that shrinking the Fed’s bond portfolio would have a greater impact on equities and other risky assets than on Treasury yields because of the impact on liquidity.

a good book

Central bankers are often accused of fighting the last war.about what Joe Biden?