Andrew Sheets: Balance Sheets Take a Back Seat

With so much going on in markets, some moves that may have been hot topics against a less chaotic backdrop, such as policy shifts towards shrinking central bank balance sheets, are hitting the back burner.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, June 17th, at 2 p.m. in London.

There is so much going on in markets that events that would usually dominate discussions find themselves relegated. You'll emerge from an investor meeting having discussed everything from Fed policy to China's COVID response, and realize there was no time for a discussion of, say, the situation in Japan where the yen has just seen one of its sharpest declines in the last 30 years.

I think that applies, in a notable way, to the conversation around central bank balance sheets. For much of the last decade, the bond buying of central banks, also known as quantitative easing, was the dominant market story. That buying is now reversing with the balance sheet of central banks in the U.S., Euro area, the UK and Japan, set to shrink by about $4 trillion between now and the end of 2023. And yet, with so much else going on, this quantitative tightening really feels like it's taking a backseat.

One reason is that while the size of this balance sheet reduction is large, it is, for the moment, looking like it will be quite predictable, with central banks stating that these reductions will happen in a regular manner, almost regardless of market conditions. That's in sharp contrast to the situation in interest rates, where central bank policy has been rapidly changing, much less predictable and very dependent on incoming data.

We were reminded of this again on Wednesday, when the Federal Reserve decided to raise interest rates by 75 basis points, on top of the 50 basis point rise they executed last month. In the press conference that followed Chair Powell emphasized how important incoming data would be in shaping further interest rate decisions. With every data point potentially shifting the near-term interest rate outlook, the steady decline of the balance sheet all of a sudden becomes less pressing.

There is also a legitimate question of how much central bank bond purchases mattered in the first place. There's a whole branch of statistics designed to test how much of the variance of one thing, like stock prices, can be explained by changes in another thing, like central bank balance sheets. When we put the data through these rigorous tests, most of the stock market moves over the last 12 years are explained by factors other than the central bank balance sheet.

And one final piece of trivia; bond prices have tended to do worse when Fed bond holdings were rising, and better when bond holdings were shrinking. That might sound counterintuitive, but consider the following. Quantitative easing usually began when the economy was weak and bond prices were already high, while quantitative tightening has occurred when the economy was strong and bond prices were already lower. It's just one more example that the balance sheet is one of many factors driving cross-asset performance.

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