In the months since short-term borrowing costs spiked last September and the US Federal Reserve stepped in to pump tens of billions of dollars into the financial system, officials at the central bank have sought to prepare markets for the day they stop pumping.
On Wednesday, Fed chairman Jay Powell put market participants on notice, reiterating that the central bank intended to slow down its interventions later this year when the amount of cash swilling around the system reaches an “ample” level. Mr Powell said he expected that to happen sometime in the second quarter.
Despite that warning, investors say they still fear what may happen when the Fed begins to extract itself, cautioning that there could be a sizeable sell-off in parts of the market that have seen a lift in recent months.
“If the Fed does stop buying, which it will do, how do they do that without triggering an unwarranted reaction?” said Priya Misra, head of global rates strategy at TD Securities. “The Fed is a little trapped now.”
In addition to intervening daily in the repo market — where investors borrow cash in exchange for high-quality collateral such as Treasuries — the Fed has also expanded the size of its balance sheet by buying short-dated Treasury bills, which mature in a year or less, at a pace of $60bn a month. When the Fed buys securities, it credits banks with reserves, thereby driving up the amount of available cash that can then be lent out to other investors.
Mr Powell pushed back once again on Wednesday on the idea that such support is akin to the post-crisis programme known as “quantitative easing”, which helped to relax financial conditions and stimulate the economy.
Some investors view things differently, noting that measures of stress in the financial system have dropped to their lowest level on record, according to the St Louis Fed, while US equities have bounded from one high to the next.
Since October, the Fed’s balance sheet has grown to $4.1tn; $300bn higher than when funding markets seized up in September. Bank reserves have increased as well, and sit at $1.6tn. Meanwhile, the S&P 500 has gained nearly 8 per cent, even after some recent losses as the coronavirus outbreak unnerved investors.
Steven Oh, global head of credit and fixed income for PineBridge Investments, said there were other catalysts driving markets higher — namely the signing of a trade deal between the US and China, and the clearing up of other key hazards to global growth. But he said the perception that the Fed has become the main driver is a “risk”.
The central bank needs “to be mindful of that in attempting a smooth transition” away from its interventions, he said.
According to Seema Shah, chief strategist at Principal Global Investors, the central bank does deserve credit for flagging its transition far in advance, slowly weaning the market off its funding by incrementally reducing the size of its operations and making assurances it will adjust the pace of that reduction as needed. But, she warned that the chances of increased volatility when the Fed tapers that support remain high.
“Usually when they have something which has been so well-flagged, the market shouldn’t really react, because it would have already been priced in,” she said. “But this is one of those things that if and when they do it, they are still . . . going to have a negative reaction because you are physically taking the liquidity out.”
For Ms Misra, a large-enough sell-off could even prompt the Fed to adjust its monetary policy stance — something it has signalled it does not want to do, unless the economic outlook sours.
“My biggest fear is they stop in the middle of the year and the market sees this as QE ending,” she said. “You could see a tightening of financial conditions . . . and if you get a 10 per cent drop in equities, do they have to come in and start cutting rates?”
Kristina Hooper, chief global market strategist at Invesco, said that one way of offsetting volatility stemming from a withdrawal of support would be a permanent facility that allows institutions to exchange their Treasury holdings for cash at a set interest rate. The Fed has discussed the need for such a programme for months, but on Wednesday, Mr Powell said the Fed had yet to make a decision.
“One of the reasons you still have some hesitance with repo is because [investors] are waiting for the other shoe to drop and for the Fed to pull out,” Ms Hooper said. “If they have a standing repo facility, that will calm things down.”