Watch Out For The Balance Sheet

It’s not just interest rate changes that affect the markets, changes in the Fed balance sheet can also be a source of negative returns to equity and bond markets. Systematic macro strategies can be a compelling approach to diversify this risk, generate alpha, and mitigate downside. We view today’s environment as a time when macro investors can profit by focusing on valuation, moving their assets, and avoiding trouble spots.

The macro environment is changing. These changes are becoming more rapid, and more permanent. Inflation is starting to look less transitory and wage pressure is starting to look real. Most importantly, central banks everywhere are starting to become much more hawkish about the future of monetary policy and how they intend to keep inflation at bay. With this, central banks are talking about the potential for raising rates and balance sheet reductions. Both appear inevitable, and both will impact markets.

Much has been written about the expected impact that rate rises will have on assets. In summary, the potential for increases in rates doesn’t bode well for future asset prices. Valuations have already been pushed to extremes and rate rises may add downside pressure. Arguably, we can take this as given.

But what about the reduction in central bank balance sheets? Given the massive injection of liquidity that we have seen, what impact has this had on the markets and what will be the impact of removing these funds? This question seems to have received much less attention, and undeservedly so. Even with a passing glance, the relationship between the Fed balance sheet and S&P 500 P/E (Exhibit 1) should spur a legitimate question about how much expanding the balance sheet has contributed to pushing up equity valuations. What happens when this reverses?

In an upcoming article in the Financial Analysts Journal by Professor Talis Putnins from the University of Technology, Sydney, the author addresses this question by analyzing how the expansion of the Fed balance sheet has impacted equity markets. (The draft is available on The article shares many of our concerns about the sustainability of inflated asset prices. We on the GMO Systematic Global Macro team have run similar analysis to the author to evaluate the effects on macro – and our own Systematic Global Macro strategy – to see if macro funds are similarly exposed to risks from a change in the balance sheet.