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Starting from next week, the market will be left without life support
Summary: This week marks the end of the Federal Reserve’s QE program. Next week, the market will be lacking the life support it received since March 2020, making it prone to volatility and tantrums. Ironically, the same week the Fed's balance sheet stops to expand, the market will need to weather a hawkish FOMC meeting and a possible Russian default.
This week is crucial for markets because it marks the end of life during the pandemic QE program. Since March 2020, the Federal Reserve has purchased nearly $6 trillion worth of mortgages and US Treasuries. This Wednesday, the central bank conducted its last purchasing operation in Treasuries, and it will conclude the last purchase of mortgage bonds today.
Although the Fed announced the end of the program plenty in advance, the market is underestimating the change that it will bring in financial markets starting from next week.
Indeed, starting from Monday, the market will test volatility amid a possible default of Russia and a hawkish Fed for the first time in two years.
There is another thing to consider: not only is the Fed expected to hike interest rates, but we might get news concerning its asset normalization policy, also known as quantitative tightening (QT). During January's FOMC meeting, the Federal Reserve flagged its willingness to start to wind down its balance sheet sooner than expected. It wouldn't be surprising to get more details about it next week, as a combination of rate hikes and quantitative tightening might help to tighten the economy more efficiently. Indeed, while rate hikes lift the front part of the yield curve, QT could initially help raise the long part of the yield curve, increasing borrowing costs. However, there is a critical point to make. Long-term yields rose initially during the 2018 QT cycle and then dropped amid volatility. The Fed had to stop QT all of a sudden as the situation in markets was deteriorating markedly.
We cannot exclude that the same will happen this time around, significantly since credit spreads have been widening on the rumors that a rate hike or QT was imminent. Both the CDX high yield and investment grade have risen above their 10-year average, while the Move Index remains sustained above levels previously seen during the Covid pandemic.
Everything points to a possible tantrum ahead of us, and now that support is all of a sudden taken away from under our feet, anything could spark it.