How the Fed balance sheet reduction might affect your portfolio

TL;DR

• Apart from raising interest rates, the US Federal Reserve will be reducing the size of its balance sheet from June to curb inflation.
• This means that the Fed will be reducing its purchases of assets, which will lead to less money being circulated in the economy.
• The last time the Fed reduced its balance sheet in 2017, the S&P500 dipped by 10% in the span of two weeks.
• The US market has corrected by more than 10% in anticipation of the Fed tightening, which suggests that some of these concerns have been factored into the share price. However, it is clear that the days of ample liquidity are over!

What happened?

Homeowners beware! The US Federal Reserve (Fed) has just announced a half a percentage point (0.5%) increase in its benchmark policy rate.

This follows an earlier increase in April, and will likely not be the last as inflationary pressures have become a major concern for central banks around the world.

Apart from the increase in interest rate, the other thing that might have caught your eye is the planned reduction in the Fed balance sheet.

Starting from the Global Financial Crisis in 2008, the Fed had to purchase assets at a large-scale in order to prevent the complete collapse of our financial system.

Similarly, when the world was hit by the coronavirus in 2020, we saw the largest asset purchase in history.

Through the purchase of assets including US treasuries or mortgage-backed securities, money supply in the economy is increased.

With the injection of liquidity into the economy and purchase of assets, asset prices have also gone up over time.

The Fed’s balance sheet reflects the amount of assets that the Fed owns through such purchases. As of today, it comes close to a staggering US$9 trillion!

What does this mean?

Starting from 1^st June, the size of the Fed’s balance sheet will be reduced by $47.5 billion per month for three months, and $95 billion per month thereafter.

The Fed can reduce its balance sheet in one of two ways: allow the balance sheet to gradually unwind itself, or to selling securities they own on their balance sheets.

In the unwinding of balance sheet, the Fed will reduce their investments in new assets when existing assets reach their maturity and are paid off.

As the securities held by the Fed are reduced, there will also be less money circulating in the economy.

The selling of securities represents a more aggressive approach to balance sheet reduction, as it could lead to downward pressure and volatility in bond markets.

What would Beansprout do?

In 4Q17, the Fed conducted a balance sheet reduction by taking an unwinding approach.

Upon release of the news, the S&P500 reacted strongly and fell by 10% in less than 2 weeks.

Things might be looking a little different this time round, as the US market has already corrected significant in recent months in anticipation of the Fed interest rate hike and balance sheet reduction.

From its recent peak, the S&P 500 index has fallen by more than 10%. This might suggest that some of the concerns might have been factored into the share price.  

While we would continue to stay invested, it is clear that the days of ample liquidity when all asset prices would keep going up (think 2020) are over.

Our portfolio would also be in stocks that we believe are supported by strong fundamentals, and can continue to do well in the event of an economic slowdown.

Find out why we prefer value stocks over growth stocks with the inflation risks this year.