The Other Doomsday Scenario Looming Over Markets
A U.K. fund manager says the big worry isn’t inflation, it’s the Fed reversing quantitative easing
By James Mackintosh on Sept. 3, 2022 10:00 am ET
Think inflation is the biggest threat to your investments? Perhaps not: One fund manager that successfully navigated the past two major stock crashes is bracing for an awful end to the year because it fears the Federal Reserve’s quiet exit from bonds.
London-based Ruffer LLP is concerned that the accelerating runoff of the Fed’s Treasury holdings will suck liquidity out of the markets—just as rising rates and falling stock and bond prices increase the need for cash to smooth the drop.
“It puts a pincer on equities and bonds at the same time,” said Alex Lennard, investment director at Ruffer. It could be “the sort of event you tell the grandchildren about.”
Ruffer is far from the only investor growing queasy at the prospect of the Fed’s quantitative tightening, which is reversing the huge growth in the central bank’s balance sheet since quantitative easing began in 2008.
But it is perhaps the most surprising. Ruffer, which runs money for institutions and private investors, spent much of the past decade prepping for inflation by accumulating a massive holding in the longest-dated inflation-linked bonds available, 50-year debt issued by the British government. Now it is holding 40% of its assets in cash and equivalents, an investment that cannot keep up with inflation.
Ruffer has a decent record when it comes to crises: Its funds barely dropped in the 2020 lockdown that took stocks down by a third, and made money as markets plunged in 2008-09. But it has underperformed in bull markets.
The Fed doubles the pace of its bond runoff this month, aiming to reduce its Treasury holdings by $60 billion and its mortgage-backed securities by $35 billion monthly. Those concerned about the impact include hedge fund giant Bridgewater, which thinks markets will fall into a “liquidity hole” as a result.
Bank of America equity strategist Savita Subramanian says QT alone could lead to a 7% stock price drop as the boost from QE is reversed. Steven Major, global head of fixed-income research at HSBC, thinks the interaction of QT and the plumbing of the financial system is too complex for anyone to predict properly. “The truth of it is that no one really knows,” he says, including the Fed.
The last time QT was tried, under Fed Chairwoman Janet Yellen, now Treasury secretary, it went perfectly—until it suddenly didn’t. Ms. Yellen said the predictable pace of balance-sheet reduction starting in 2017 should be “like watching paint dry,” and for two years it was. Then in 2019 the overnight lending market—crucial to the financial system and reliant on plentiful reserves—seized up, forcing an emergency rescue to prevent a full-on credit crunch.
QT is a bit different this time, the main reason that Ruffer is so fearful. Before we get into it, a quick reminder on central bank reserves for those who haven’t delved into the monetary system for a while. The Fed creates reserves as a special form of dollars that can only be held by banks and some similar firms, that they use to settle debts to each other. (The rest of us mostly use bank-created electronic money, plus physical dollars.) Since QE began, reserves have ballooned as the Fed created reserves to buy bonds from banks.
Unlike in 2017, large quantities of reserves have been returned to the central bank via money-market funds. These funds, which savers use as a liquid alternative to savings accounts, are allowed to deposit money at the Fed overnight using reverse repurchase agreements (RRPs), and have already sucked $2.2 trillion of reserves out of the system, up from zero at the start of last year.
For now, the loss of reserves isn’t a problem. Banks had too many deposits and reserves anyway, and they still have $3.3 trillion of reserves, more than they had ever held until last year. But there are risks.
Ruffer’s concern is that the loss of reserves will impede the banks’ willingness to take risks. That doesn’t matter too much when markets are calm, but, to put it mildly, they aren’t. Ruffer expects widespread withdrawals from fund managers after the terrible year they’ve had, forcing sales of stocks and bonds. If banks are constrained and unwilling to deploy money, they won’t cushion price declines and markets could drop suddenly.
A wonkier concern is that the loss of reserves to money-market funds will drain the banks so much that their reserve levels approach the minimum the Fed thinks is needed to avoid a repeat of the 2019 breakdown. Deutsche Bank strategist Tim Wessel argued in a recent note that the Fed would probably stop QT when the banks have $2.5 trillion of reserves.
If money-market funds keep grabbing deposits and parking them with the Fed’s reverse repo facility, that could be reached as soon as January, he says—forcing the Fed into an embarrassing early end to QT. As an alternative, it could cut the rate it offers money-market funds to try to shift money back to bank deposits instead.
Where this stops being wonky is that an early end to QT would mean higher rates would be needed for the Fed to tighten policy the same amount, something sure to hit stocks.
The problem with these risks is that they’re real, but it’s impossible to say if or when they will hit. I don’t have enough confidence that trouble is so imminent that investors need to go heavily into cash the way Ruffer has. There are enough other issues—especially the market’s failure to prepare for weaker earnings next year—to keep me bearish on stocks, but inflation makes cash an expensive place to hide. Still, QT is a risk to watch closely, because it’s only boring until it suddenly isn’t.
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