Rising oil prices and a sweeping US tax cut are raising a red flag for the bond market

As we approach the end of an economic cycle, balance sheets are of paramount importance. It explains why investors are becoming worried about the level of corporate debt accumulated over the past decade.

But right now one shrinking balance sheet looms over the entire financial system: that of the US Federal Reserve. The importance of the Fed’s vast holdings of bonds being allowed to diminish at what appears a modest pace of $50bn a month was rammed home this week when Fed chair Jay Powell addressed the subject in a press conference.

Having raised overnight rates and lowered expectations for the pace of tightening in 2019, Mr Powell sparked a very negative reaction in equity and credit markets when affirming the $50bn pace of monthly contraction was on “automatic pilot”.

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The central bank’s rationale is that a consistent message on the balance sheet, which ballooned thanks to the Fed’s quantitative easing programme, is helpful to investors. However, it also suggests that even if the bond market has ultimately made the right call on no more rate tightenings next year, a shrinking balance sheet means investors still face the loss of easy liquidity. What’s more, when the Fed chair tells markets that the central bank’s decisions are data dependent, but then sticks to an existing plan on the balance sheet, he has a major communication problem.

The consensus among investors is that the suppression of government bond yields via QE boosted risk assets such as equities and credit. As the Fed unwinds its balance sheet and the European Central Bank ends its own bond-buying this year, analysts at TS Lombard estimate that “net liquidity provision by the G4 central banks will start to contract by the start of next year”.

As the pace of quantitative tightening quickens, a painful repricing of equities and credit is unavoidable. For much of the year, Wall Street handled this very well with a US tech-led Wall Street the clear winner as emerging markets and other developed world equities markets suffered during the summer.

Since October, the gap between US markets and the rest of the world has narrowed sharply and accelerated as the end of the year nears. Now is the period when fund managers — whose performance is judged over the course of a year — trim positions, booking gains and losses for the year. However, this year the standard behaviour has been swamped by a huge flight for the exit.

The S&P 500 is down 12.5 per cent alone this month, while the FTSE All World index (excluding the US) has dropped 6 per cent. Nor is there yet any sense of reprieve for what has been a poor year for most asset classes. That the S&P 500 faces its worst December since 1931 says much about the stresses in the market.

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One explanation for the violent reaction in equities to Mr Powell’s comments on the balance sheet is that investors believe the approach increases the chances of a policy mistake in which the central bank tightens too much and ultimately tips the economy into a recession.

And the subsequent fall in value of riskier assets could feed on itself. Selling is begetting selling as falling equity and credit prices compel capitulation by investors. No matter that equity valuations are becoming ever cheaper, alongside the fact that the US economy and corporate profits are both still set to expand next year, the current mood is all about exiting riskier assets.

The difficulty facing both investors — who should be scouring for bargains amid the debris — and Fed policymakers is trying to work out how much further the unwinding of trades and portfolios built on leverage during the era of cheap money has to run. The general suspicion is there is more to go, particularly should fund redemptions early next year force more selling of equities and credit.

Such a scenario raises the danger that the grim market mood infects business and consumer sentiment, a risk acknowledged in the Fed’s policy statement this week when it referred to “financial developments” and “their implications for the economic outlook”.

These episodes tends to end with the Fed, after a period of resistance, relenting and giving the market time to settle down so to shield the economy from harm. If the current market tempest continues blowing into 2019 — and we see little traction on Sino-US trade or any signs of weakness in the US economic data — then a Fed pause will arrive quickly.

When Mr Powell holds his next press conference following the meeting of Fed policymakers in late January, we should have a better sense of whether the current market angst is mainly noise or something far more worrying for the central bank. Until then, it’s a matter of holding fast into the teeth of the gale.

michael.mackenzie@ft.com

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