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Merk: What Does Fed’s Shrinking Balance Sheet Mean for Stocks, Bonds & Gold?

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The Federal Reserve’s “balance sheet reduction” may have profound implications for gold, stocks and bonds, according to Axel Merk’s latest insights.

The Fed wants to start winding down its $4.5 trillion bond portfolio. According to the minutes from its June meeting, the Federal Reserve policy committee couldn’t reach agreement on the timing of when to begin shrinking its massive balance sheet – although Merk expects a formal announcement in September.

“Unless markets fall apart in the coming weeks, we expect that the formal announcement for the Fed’s balance sheet reduction will be made this September, with a gradual stepping up in the amount the Fed will allow to ‘run off,’ i.e. the amount of maturing bonds it won’t re-invest,” Merk writes.

While the Fed left many details open to interpretation, at first $6 billion may be allowed to run off – looking at Treasuries alone – and this is gradually stepped up until $30 billion a month may be allowed to run off, Merk says.

In addition, Merk says that the Fed will allow mortgage-backed securities to run off.

“There’s really no good reason to look at Treasuries and [mortgage-backed securities] in isolation; as such, the balance sheet reduction would be $50 billion a month if the program were to be fully deployed,” according to Merk.

The Fed hasn’t announced how small a balance sheet they want to have, and Merk says “this is because the Fed neither knows, nor agrees of where they want to take the balance sheet.” However, he adds, that this hasn’t stopped the Fed from “preparing the markets” that it is embarking on this journey.

Merk looks at the possible implications quantitative tightening could have on bonds, stocks and gold. (If printing money is quantitative easing, then Merk says balance sheet reduction is quantitative tightening.)

Implications for Treasuries

Some argue quantitative tightening will cause Treasuries to fall. Merk’s take is that this won’t happen. Instead, he thinks risk premia will rise.

With regard to to Treasuries, rising risk premia imply deteriorating financial conditions, a headwind to economic growth, according to Merk.

“Treasuries may end up not changing all that much, possibly even rise,” Merk says.

Implications for stocks

Stocks are historically correlated to junk bonds, not because they are junk, but because they are both so-called risk assets.

“Just as their volatility has been compressed with QE, we believe their volatility should rise with QT,” Merk writes.

Merk calls outburst in the tech sector “the canary in the coal mine,” and he thinks the “buy-the-dip mentality” is wearing thin. He also thinks that the end-of-day buying that had become routine may have turned into end-of day selling on several occasions of late.

“Does that mean that there isn’t value out there somewhere?” Merk writes. “Possibly, but don’t come crying to me if you lose money holding stocks in this environment.”

Implications for gold

With rates rising, should the price of gold decline? Merk can see Eurozone based investors getting less enthusiastic about gold as the euro has been rising. However, he thinks rising risk premia may be a positive for the price of gold.

“Because gold does not have cash flow, there’s also no greater discounting of future cash flows as risk premia rise,” he writes. In contrast, stocks may well be under pressure as risk premia rise.

According to Merk, gold could be a valuable diversifier should stocks suffer.

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