End of Imaginary Stimulus May Be a Real Risk to Markets in 2020

(Bloomberg) -- The Federal Reserve may be inadvertently setting the stage for more market turmoil in 2020 because it can't persuade investors to ignore its multitrillion-dollar balance sheet.

The Fed's withdrawal from “non-QE” is the biggest risk facing investors next year, according to strategists from John Hancock Investment Management. They say the central bank's purchases of $60 billion a month of Treasury bills, along with the three rate cuts delivered between July and October, have helped to untwist the Treasuries yield curve and boost risk assets.

But policy makers have repeatedly insisted that their purchases aren't a reboot of the quantitative easing program designed to pull the U.S. economy out of the last financial crisis. This exercise is a plumbing job to ease the flow of funds in the financial system. The Fed expects it to run into the second quarter of next year, but already it's looking like they might have trouble wrapping it up.

“One of the things that we think is primarily responsible for buoying risk assets this year is the giant amount of liquidity that the Fed has injected into markets,” said Emily Roland, who was presenting alongside her co-chief investment strategist Matthew Miskin at their 2020 outlook presentation this week.

“We've got almost a fourth cut from the Fed using the balance sheet,” Miskin said. “The problem is what if they stop?”

The combination of Fed repurchase agreement operations and T-bill buying has pumped almost $300 billion to replenish cash in the financial system and support short-term funding markets, which suffered a nasty squeeze in September. It's not lost on many market participants that this exercise has coincided with strong gains in U.S. stocks.

This isn't the first time the Fed has tangled with markets over how it's managing its multi-trillion-dollar portfolio. This time last year, as stocks were throwing a tantrum that took the S&P 500 Index down more than 15%, investors blamed the Fed's efforts to shrink its crisis-era portfolio of assets that was already underway.

The Fed had variously attempted to brand that exercise, dubbed quantitative tightening, as a technical process, on “automatic pilot,” and as dull as “watching paint dry.” It pivoted sharply on that message in January, tapering and then halting the balance sheet unwind.

September's money-market upheaval raised criticism that the process went too far, and led to a scarcity of reserves. The Fed has been at pains to point out that its T-bill purchases are aimed at addressing only this problem, not to lower benchmark borrowing rates to support the economy and broader markets.

But policy makers may find they need to hammer this message harder, and provide a very clear exit strategy, if they want a no-tears withdrawal from this non-QE policy.

--With assistance from Alexandra Harris.

To contact the reporter on this story: Emily Barrett in New York at ebarrett25@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Debarati Roy, Elizabeth Stanton

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