Morgan Stanley Securities issued a report on May 25, advising investors on how to respond if the Fed were to reduce its massive balance sheet.

Federal Reserve policymakers had previously hinted at plans of a balance sheet reduction starting at the end of last year.

But none of this has impacted the financial market, even with Morgan Stanley Securities’ warning that this should be a priority concern with effects only likely to start emerging in the second half of this year. And it seems only a few investors are really worried about this happening.

It’s little wonder. Not a lot of people even know what ‘reducing its balance sheet’ means exactly.

The impact of the Fed reducing its balance sheet could be bigger than people are expecting

Investors Warn of Bubble Bursting: To help stabilise the financial system after the 2008 financial crisis, the Federal Reserve introduced the first so-called quantitative easing policy that October — purchasing large quantities of securities and printing money to promote economic recovery.

But this also expanded the Fed’s balance sheet, which stand at about $4.5 trillion today.

The Fed’s money printing and asset buying flooded the market with capital, pushing up the price of various financial assets.

While some in the market are excited about the all-time highs that have ensued, fund manager Bill Gross said last week that US markets were at their highest risk levels since before the financial crisis.

“Instead of buying low and selling high, you’re buying high and crossing your fingers,” Gross said, indicating that investors are paying a high price for the chances they are taking.

The following day, legendary investor Jim Rogers echoed Gross’ views, predicting there would be a market crash in the next few years that would rival anything in his lifetime — and, at 75 years old, Rogers has observed all major financial crises besides the Great Recession in the 1930s.

Just how big a threat to the global financial system does the Fed’s massive balance sheet pose in the second half of 2017? The answer lies in the ‘math problem’ cited by the Morgan Stanley analysts.

They asked: what happens when a big trader, who consistently trades in large quantities and only buys and never sells, is about to withdraw from the market?

If the Big Buyer Leaves: The ‘big buyer’ in question is the Fed. And from the information at hand, policymakers with the Fed are very cautious and are more likely to gradually shrink their assets by reducing investments once securities expire.

“We are in unchartered waters today, and we shouldn’t expect it to be smooth sailing,” the analysts said, adding that a drop in securities prices on the unwinding of the Fed’s balance sheet can translate into higher yields on Treasuries — by removing a big buyer and pushing more inventory into the market.

The stock market won’t escape a hit either, since when bond yields exceed dividend yields would be considered a tailwind for the bond market.

The China Post/ANN

Published in Dawn, The Business and Finance Weekly, June 26th, 2017