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Fed Watch: Why Shrinking the Fed’s Balance Sheet Could Affect Stocks

Fed Watch: Why Shrinking the Fed’s Balance Sheet Could Affect Stocks

Experienced investors understand that in general, the stock market isn’t a single-engine machine. Many different factors contribute to the market’s rises and falls. Economic growth expectations, momentum and stock valuations all play a role, as do the waxing and waning enthusiasms of individual investors. Disasters, politics and other non-financial bogeys can also intrude with unsettling—if temporary—effect.

And then there’s the influence exerted by the Federal Reserve, America’s central bank. The Fed adjusts short-term interest rates and deploys other monetary tools to help manage two key characteristics of the economy: employment and inflation. Sometimes the Fed’s actions end up being “good” for the market, in the sense that they can make investors more keen on stocks, even if that wasn’t the Fed’s goal. Other times, the Fed can be a source of uncertainty.

We may be on the verge of such a situation now.

One thing seems certain

In the past, one source of uncertainty linked to the Fed had to do with whether it would change its benchmark interest rate—known as the federal funds rate—at its monthly meetings. The federal funds rate is an important benchmark that indirectly affects financial markets and many consumer rates. In general, raising the rate tends to serve as a brake on the economy because it can make borrowing more expensive. Cutting it can have the opposite effect.

For that reason, you might expect rate hikes to hurt stocks and cuts to boost them. However, the relationship between rates and the stock market isn’t totally straightforward. For example, if the Fed raises its benchmark rate because the economy is growing strongly, then the stock market might not care—so long as the economy continues to grow. And slashing rates in the hope of preventing a sharp slowdown in growth can be a portent of bad things to come.

Where do things stand now? Market expectations for a rate hike at the Fed’s June meeting are hovering around 100%, based on the federal funds futures market. That would be the fourth such hike in the rising-interest-rate cycle that started in late 2015, after the Fed kept the rate around zero for years to ease the effects of the 2008 financial crisis.

The case for another hike—and potentially a fifth one in September, too—is that the economy appears to be healthy enough to take higher rates. And initial jobless claims, which continue to be remarkably low, suggest a continued tightening in the labor market. From a broader perspective, the Fed is also keen to return rates to a historically “normal” level to ensure it has enough monetary policy firepower to respond to any future slowdowns in the economy.

From that perspective, the market would seem to have little reason to worry about higher rates. In fact, data from Ned Davis Research indicate that stocks—and the economy—have generally fared pretty well during past rate-hike cycles. For example, the S&P 500® Index delivered an average return of 9% during the rate-hiking cycles going back to 1946.
However, interest rates aren’t the only lever of the monetary machine that could soon be manipulated.

Balance sheet uncertainty

The Fed is also looking for ways to scale back some of the roughly $4.5 trillion of assets currently sitting on its balance sheet. Think of them as another legacy of the financial crisis. In addition to slashing interest rates in response the the crisis, the Fed also bought Treasury and mortgage-backed securities as part of an unprecedented effort to inject more money into a wobbly economy—a strategy known as “quantitative easing.” Shrinking the Fed’s balance sheet by shedding some of these securities is part of its return to normal. 

The problem is that managing this process could cause volatility, as the simple fact that the Fed won’t be maintaining its large pile of assets will tighten monetary conditions at a time when the Fed is already raising interest rates.   

“Shrinking the Fed’s balance sheet is a form of tightening. In fact, you’re probably going to hear a lot more looking ahead at this transition from QE to QT—quantitative easing to quantitative tightening,” says Liz Ann Sonders, chief investment strategist for Charles Schwab & Co. “The Kansas City Fed found that a 15% reduction in the Fed’s balance sheet would be the equivalent of raising interest rates by about 25 basis points.”

How this might affect the stock market is unclear. Looking back a few years, announcements by the Fed about pausing its asset purchases were accompanied by stock market volatility. Having the Fed reduce its holdings—perhaps by allowing securities to roll off as they mature instead of reinvesting the proceeds—could bring some of that uncertainty back.

Transparency

Of course, Fed officials are aware of how big an impact they can have. That’s true of both their actions and their comments. Even unguarded musings about potential future actions can set markets scrambling.

“The Federal Open Market Committee has begun telegraphing its plans for the timing of, and process for, shrinking the balance sheet,” says Liz Ann. “One concern is that the FOMC’s many talking heads will confuse markets, especially given that we will soon be in an era of both rate hikes and balance sheet reductions.”  

When might we know more? Not every Fed meeting has a press conference—the four press conferences this year are scheduled for March, June, September and December. Assuming this year’s June press conference focuses on interest rates, September or December could be good candidates for further word about the Fed’s plans for its gargantuan bond holdings.

“We’re guessing that if Fed officials step up their communications about their plans to shrink the balance sheet, they may not do that during a meeting at which they also raise interest rates,” says Liz Ann. “So while a September rate hike is still fairly likely, they may also take the opportunity to stop there for a spell and refocus their attention on the balance sheet.”

No reason to panic

All things considered, investors shouldn’t worry too much about a continuation of the rate-hike cycle. As noted above, stocks performed fairly well in past cycles, as did the economy more broadly. Quantitative tightening could make things a little more complex this time around, which could lead to volatility in the months ahead. But if you have a well-diversified portfolio and a solid financial plan, you can probably feel a little more confident about your ability to stomach any short-term swoons. 

What you can do next

  • Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
  • Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.
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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.      
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Investing involves risk, including loss of principal.

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