Consider inflation is the biggest threat to your investments? Maybe not: One fund manager who successfully weathered the last two major stock market crashes is bracing for a terrible end to the year because he fears the Federal Reserve’s quiet exit from bonds.
London-based Ruffer LLP is concerned that the acceleration a drain on Fed treasuries will suck liquidity out of the markets — just as rising interest rates and falling stock and bond prices increase the need for cash to smooth out the downturn.
“It puts a clamp on stocks and bonds at the same time,” said Alex Lennard, chief investment officer at Ruffer. It might be “the kind of event you tell the grandkids about.”
Ruffer is far from the only investor worried about the prospect of quantitative easing by the Fed, 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, who manages money for institutions and private investors, has spent much of the past decade preparing for inflation by building up a huge stake in the longest-term inflation-linked bond available, 50-year debt issued by the British government. It now holds 40% of its assets in cash and cash equivalents, an investment that can’t keep up with inflation.
Ruffer has a decent track record when it comes to crises: His fund barely budged during the 2020 lockout, which sent shares down by a third, and made money when markets crashed in 2008-09. But it didn’t perform well in bull markets.
The Federal Reserve is doubling the pace of its bond yields this month, seeking to reduce its holdings of Treasuries by $60 billion and its mortgage-backed securities by $35 billion a month. Those concerned about the impact include hedge fund giant Bridgewater, which believes markets will fall into “liquid hole“ as a result.
Equity strategist Savita Subramanian says QT alone could lead to a 7% drop in the share price as the QE push is reversed. Stephen Major, global head of debt instruments research at HSBC, believes the interaction between QT and the financial system’s plumbing is too complex for anyone to predict correctly. “The truth is, nobody really knows,” he says, including the Fed.
The last time QT was tried, under Fed Chair Janet Yellen, now Treasury Secretary, everything was going perfectly – until suddenly it did. Ms. Yellen said the foreseeable pace of balance sheet reduction starting in 2017 should be “like watching paint dry,” and so it was for two years. Then in 2019, the overnight lending market — critical to the financial system and reliant on abundant reserves — ground to a halt, forcing emergency rescue to prevent a full credit crunch.
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QT is a little different this time, the main reason Ruffer is so scary. Before we get into it, a quick reminder about central bank reserves for those who haven’t delved into the monetary system in a while. The Federal Reserve creates reserves as a special form of dollars that can only be held by banks and certain similar businesses that they use to settle debts with each other. (The rest of us mostly use electronic money created by banks, plus physical dollars.) Since QE began, reserves have grown as the Fed has built up reserves to buy bonds from banks.
In contrast to 2017, large amounts of reserves were returned to the central bank through 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 repurchase agreements (RRPs) and have already siphoned $2.2 trillion of reserves from the system, from zero at the start of last year. year.
So far, the loss of reserves is not a problem. Banks had too many deposits and reserves anyway, and still have $3.3 trillion in reserves, more than they ever held until last year. But there are risks.
Ruffer’s concern is that the loss of reserves will dampen banks’ willingness to take risks. This doesn’t matter much when the markets are calm, but, to put it mildly, they aren’t. Ruffer expects widespread withdrawals by fund managers after the terrible year they spent forcing sales in stocks and bonds. If banks are constrained and unwilling to distribute money, they will not cushion price declines and markets can fall suddenly.
The more dire concern is that the loss of reserves to money market funds will drain banks so much that their reserve levels will approach the minimum the Fed deems necessary to avoid a repeat of the 2019 meltdown.
strategist Tim Wessel argued in a recent note that the Fed is likely to stop QT when banks have $2.5 trillion in reserves.
If money market funds continue to grab deposits and park them with the Fed’s reverse repo facility, that could be accomplished as early as January, he says, forcing the Fed into an uncomfortably early QT termination. Alternatively, it could cut the interest rate it offers money market funds to try to shift the money back into bank deposits instead.
Where this stops being strange is that ending QT early would mean that it would take higher rates for the Fed to tighten policy by the same amount, something that would certainly hit stocks.
The problem with these risks is that they are real, but it is impossible to tell if and when they will strike. I don’t have enough confidence that trouble is so imminent that investors need to get heavily into money like Ruffer is doing. There are enough other issues — particularly the market’s inability to prepare for weaker earnings next year — to keep me bearish on stocks, but inflation makes money an expensive place to hide. Still, QT is a risk to watch carefully because it’s only boring until it suddenly is.
Write to James Mackintosh at [email protected]
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