Happy New Year!
New year, new Fed, new markets. Following the 27% gain in the S&P 500 for 2021, the markets are digesting the recent high inflation numbers, firming interest rates, high equity valuations, and a Fed that appears to be moving from easing to tightening mode. Add to mix the surge in COVID-19 cases and we understand why equities have weakened to start the year.
This post will focus on the Fed as the minutes from its December meeting were released this week. Although the Fed indicated last month that they would end bond purchases sooner and rate hikes likely would begin in 2022, the minutes revealed new information. To date, risk of Fed action was focused on the pace of tapering bond purchases and timing of rates hikes. Now, another risk that was lurking in the background but rarely discussed is the actual reduction in the Fed's balance sheet.
Here is an excerpt from the minutes: "Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate." With the market now expecting a rate hike as early as March, this suggests bond sales, or at least not replacing maturing bonds, could begin this year.
The chart shows Fed assets over time along with the S&P 500. At nearly $9.0 Trillion, assets have doubled from levels prior to COVID-19. But, note the market weakness in the 2018/2019 period as the Fed attempted to reduce the balance sheet. Fortunately, inflation was very low at that time, allowing the Fed to reverse course. The markets may not be so lucky this time. Happy New Year!