17 November 2019
The US Federal Reserve is widely expected to adopt a gradual approach in its balance sheet reduction move. Photo: Reuters
The US Federal Reserve is widely expected to adopt a gradual approach in its balance sheet reduction move. Photo: Reuters

Why Fed’s balance sheet unwind won’t hurt the US stock market

With the US Federal Reserve confirming that it will begin unwinding its US$4.5 trillion balance sheet, investors are concerned about the potential implications for the stock market.

How will the central bank exactly proceed with the task and how will that affect asset prices? These are some of the questions that are passing through people’s minds.

I had said earlier that the Fed is keen to raise interest rates and reduce its balance sheet for two reasons.

First, it intends to tame the soaring stock market with tightened monetary policy. Second, the balance sheet adjustment will offer some leeway for the central bank to bring down interest rates or launch another quantitative easing (QE) in the future, if needed.

Since the 2008 financial crisis, the equity market and other asset classes have seen prices move in line with central bank policies. 

Nonetheless, US stocks rebounded quickly after a brief correction triggered by the ending of QE in October 2014.

Then the stock market started to take off since late 2016, and the S&P 500 index has soared over 30 percent since Fed unwound the QE program.

That has proved that the stock market can sustain a strong performance even without monetary easing measures.

Does that mean the Fed’s rate hikes in the last two years have had no impact on the market?

QE has served as a main driving force for the US market rally since the financial turmoil. The program resulted in capital cost falling to extremely low level and helped reduce the burden for corporate borrowers.

In the meantime, it also encouraged many companies to undertake share buybacks or seek M&A deals, moves that helped prop up share prices.

Corporate credit expansion, share buyback and M&A activities stayed at relatively high levels even after the Fed’s policy reversal since 2015.

Corporate debt level has expanded at around 5 percent in the early stage of the financial crisis. The growth rate started to fall off but again rose to 6.9 percent in the first quarter of this year.

In the previous rate hike cycles, Fed usually raised interest rates to 5 or 6 percent to suppress excessive debt growth. However, the key interest rate remains at 1 to 1.25 percent now although the Fed has tightened four times over the last two years. Such low rate won’t have any material impact on corporate borrowing activity.

Secondly, the share buyback activity has leveled off since mid-2016 in both deal volumes and value. But it remains at a relatively high level, which means rate hikes have had limited impact on it.

Thirdly, M&A deals in the US market are still at a relatively high level, despite witnessing some decline after Fed started to raise interest rates 

It’s widely believed that the central bank will adopt a gradual approach in its balance sheet reduction move.

After starting the process in 2017, the Fed is expected to see its holdings cut by US$318 billion and US$409 billion respectively in the next two years.

That is equivalent to a rate hike of 22 basis points within two years, according to data from the International Monetary Fund. That means the move many not have any significant impact on the stock market.

Also, the US monetary base has more than tripled as a result of the three QE programs. Given this, a moderate reduction of the balance sheet will only have limited market impact.

We shouldn’t be surprised if the US equity market maintains its upward momentum in coming months.

This article appeared in the Hong Kong Economic Journal on Sept 21

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist