Fed prepares to shrink its US$9tn balance sheet: Mean reversion for equities?

US Federal Reserve policymakers are showing that there’s plenty of hawkishness left in the tank to deal with hot inflation and surging labour costs.

Fed Fund futures contract prices show that the most probable outcome for interest rates are around 2.75% to 3.25% by the end of the year, likely to weigh on economic growth and sparking recession fears.

Source: CME Group

Flying under the radar is the Fed's plan to reign in its covid-inflated balance sheet and what this might mean for equity markets.

The backdrop

To support financial markets and the economy during the unprecedented pandemic, the Federal Reserve more than doubled its asset portfolio of mostly Treasury, federal debt and mortgage securities to US$9tn.

The move, known as “quantitative easing” would increase the availability of debt for home purchases and lower long-term interest rates to inject more life into the economy.

Normalising isn't easy

The massive balance sheet eventually needs to be normalised and breaking that news to the financial markets isn't easy.

In a Fed December 2018 meeting, Chairman Jerome Powell said that the quantitative tightening process was on "auto pilot" - triggering an equity market selloff as investors were concerned the Fed had shrunk its balance sheet too much.

Deflating the balance sheet influences interest rates, and can even disrupt the flow of credit when taken too far.

Nasdaq Composite 2018-19 (Source: TradingView)

What about this time?

The normalising process can involve letting the bonds roll off at maturity, and greater shrinkage can achieved by actively selling them in the open market.

This time, officials have pointed towards another passive approach but at a bigger and faster pace. 

“I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19,” said Federal Reserve governor Lael Brainard. 

The passive redemptions, also known as runoff, is expected to kick off in May or June, at an indicative pace of US$95bn every month.

More details and commentary is expected at the Fed's meeting on Thursday, 5 May.

Impact for stocks

There's quite a bit of ambiguity as to what happens to the stock market when the fountain of Fed money runs dry.

A rather common view is that bountiful stimulus and ultra-low interest rates has pushed capital into speculative corners of the market like tech and cryptocurrency.

So what happens if the Fed begins to normalise such factors?

US Fed balance sheet (top) vs. Bitcoin (bottom) - Source: TradingView, Annotations by Market Index

The Nasdaq is down -23.2% year-to-date, entering bear market territory. From a technical perspective, the Nasdaq has been able to respect the upper/lower bounds of its upward trend since 2016.

As the Fed doubled its balance sheet between March and June 2020, the Nasdaq pushed well beyond this channel.

US Fed balance sheet (top) vs. Nasdaq Composite (bottom) - Source: TradingView, Annotations by Market Index

The Fed has yet to normalise its balance sheet but it looks like the Nasdaq is already trying to price in the headwinds, reverting back to the top end of its previous channel.

Does this place the Nasdaq at further risk when the normalisation process kicks off?