The Fed may be nearing the end of its rate hikes but its balance sheet reduction plans still pose a big risk to stocks.
The Fed has reduced its balance sheet by $900 billion over the past year and is showing no signs of stopping.
"Risk assets love liquidity. Continued draining of liquidity presents a risk for equities," Ned Davis Research said in a Thursday note.
The Federal Reserve may be close to the end of its rate hiking campaign based on a continued cooldown in inflation, but the central bank has one more policy move that poses a big risk for the stock market.
Since June 2022, the Fed has reduced its balance sheet by $900 billion to $7.6 trillion, and it would have been even more if the Fed wasn't forced to inject $400 billion of liquidity to contain the regional banking crisis in March.
As the Fed reduces its balance sheet by letting treasury and mortgage bonds mature (and then not reinvesting the proceeds), it is taking liquidity out of markets.
"Liquidity is the lifeblood of the financial markets... Risk assets love liquidity. Continued draining of liquidity presents a risk for equities and credit," Ned Davis Research chief global macro strategist Joseph Kalish said.
The Fed has been reducing its balance sheet by about $80 billion per month, and stocks tend to perform well when the exact opposite happens, according to NDR.
"Our analysis shows that when the 4-week change of reserves has increased by more than $62 billion, stock returns have exploded at a 31% annual rate since March 2009 when the Fed began ramping up QE and shifted to an ample reserves regime," Kalish explained.
"Conversely, when reserves have been declining by more than $38 billion over the past four weeks, stocks have struggled," Kalish said.
That means stocks could still come under pressure even if the Fed pauses its interest rate hiking cycle for good later this year, as the central bank has shown no indication of stopping its balance sheet reduction program. And its balance sheet reduction policy can have a big impact not only on the stock market, but also the economy.
"The reduction in securities shrinks bank reserves, which reduces banks' cash and limits their ability to make loans and investments," Kalish said.
That, combined with aggressive interest rate hikes over the past year, helps explain the tightening in credit conditions and the reduced willingness of banks to loan out money. But whether the Fed's ongoing tightening policies can knock down this year's stock market rally remains to be seen.
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