One of the deepest secrets on Wall Street is that very few of the horror stories traders like to tell each other ever actually come true. If you need proof, just take a look at the bond market right now.
For months, we’ve all been bracing for the Fed to start deflating its swollen $8.5 trillion balance sheet to get rid of the debt the government printed money to buy in the pandemic. In theory, liquidating that kind of portfolio could crash global markets.
And that’s the horror story. What if the Fed starts selling its bonds and not enough people step up to buy, driving long-term interest rates to levels too high for a still-fragile economy to bear?
We just didn’t know the answer. Wall Street hates the unknown, but it’s also fascinating. We literally “worry” at every problem until we have a sense of the various scenarios that might play out.
Then we plan for the worst ones. Usually, that means cutting exposure to likely risk factors, getting some distance from pain points. We’ve seen a lot of that in the last few months.
But here’s the thing. It’s June 2. The Fed’s grand balance sheet runoff — the long-dreaded quantitative tighten — started yesterday morning.
The world didn’t end, did it? So far, bond yields have edged upward without the Fed around to keep them down. The moves haven’t been extreme. A few spots on the yield curve have actually gone in the other direction.
Stocks haven’t crashed either. As I write this, the S&P 500 has dropped an insignificant 0.2% so far in the quantitative tightening era. The NASDAQ is up 0.8%. Stocks like Amazon (AMZN) and Tesla (TSLA) are soaring.
These are the stocks that featured most prominently in the horror stories . . . the ones that swelled to extreme valuations when free COVID money was flowing fast and furious, and now that the money has stopped, they’re theoretically least able to support themselves.
At least, that’s how the horror story went. And it might still have an unhappy ending. But for now, the truly worst of the scenarios are off the table.
The way the Fed is handling its balance sheet didn’t crash the market immediately. It’s been almost 48 hours. If we can get through this period, the threat changes from instant disaster to a slower drag.
Wall Street knows how to cope with drag. We innovate around it in search of investments that can defy the pressure and rise above. Disruptive companies are rewarded. Those that were once seen as “safe” become dangerously susceptible to stagnation.
But why didn’t the world end? For one thing, the Fed hasn’t been actively pumping cash into the bond market since March. What was once $120 billion a month in artificial demand for those assets has already dried up.
March was a rough transition. We saw one-month Treasury yields double while the long end of the curve swelled from a lowly 2.17% to 2.44% . . . back where it was in August 2019. We’re all coping in various ways with higher interest rates across the board.
The Fed isn’t in the market any more to buy bonds and depress those rates. After two years of Jay Powell’s toe on the scale, something like natural supply and demand is playing out now. This is “normal.”
And it isn’t killing the market. We’ve lived through much higher interest rates. Companies like AMZN and TSLA thrived in those conditions, rewarding shareholders along the way.
After all, that worst-case scenario is off the table. The Fed isn’t stupid. They aren’t planning to actively sell their bonds and push the supply-demand calculations even an inch in the wrong direction. We know this because they’ve told us.
The thing about bonds is that they mature. When they mature, you cash them in. Then, you can either roll them over by buying new bonds or keep the cash.
That’s how the Fed is reducing its balance sheet. The last numbers I saw showed $423 billion in debt on the balance sheet maturing in the next 90 days. The Fed has committed to putting about $330 billion of that cash back to work, but the other $90 billion will simply vanish.
(There’s a trick to the Fed’s plan. They say they’ll also start letting $17 billion a month in housing agency debt expire, but very, very little of that paper actually matures in the next decade, so it’s a moot point. Read the fine print.)
The printing press can run in reverse. That’s what’s happening now. So far, it’s slow . . . the balance sheet is shrinking 0.3% a month . . . but it’s good to tiptoe around the apocalypse before you start to run.
Either way, the world hasn’t ended. Today’s weekly auction of short-term Treasury paper didn’t show much stress at all.
And when Wall Street realizes yet another scary story didn’t lead to the end of the world after all, what do we do? We cheer in relief. We’re still here. Time to get back to work.