The other scenario of the Crisis that is looming in the markets

Do you think inflation is the biggest threat to your investments? Maybe not: A mutual fund manager who successfully weathered the last two major stock crashes is bracing for a dire end to the year because he fears the Federal Reserve’s quiet exit from bonds.

London-based Ruffer LLP worries that the accelerating outflow of the Fed’s Treasury holdings will siphon liquidity from markets — just as rising interest rates and falling stock and bond prices increase the need for cash to smooth out the fall.

“It’s pinching stocks and bonds at the same time,” said Alex Lennard, chief investment officer at Ruffer. It could be “the kind of event you tell the grandkids about.”

Ruffer is far from the only investor worried about the prospect of the Fed’s quantitative tightening, which reverses the massive growth of the central bank’s balance sheet since quantitative easing began in 2008.

But it is perhaps the most surprising. Ruffer, who manages money for institutional and retail investors, has spent much of the past decade preparing for inflation by amassing a huge holding in the available longer-term inflation-linked bonds, 50-year debt issued by the British government. It now holds 40% of its assets in cash and cash equivalents, an investment that can’t keep up with inflation.

Ruffer has a decent record when it comes to crises: Her funds just got through the 2020 lockdown that sent shares down by a third, and she made money as markets tumbled in 2008-09. However, it has underperformed in bull markets.

The Fed is doubling the pace of its bond outflows this month, aiming to reduce its Treasury holdings by $60 billion and its mortgage-backed securities by $35 billion a month. Those worried about the impact include hedge fund giant Bridgewater, which believes markets will fall into a “liquidity hole” as a result.

Bank of America equity strategist Savita Subramanian says QT alone could send the stock down 7% as the push from QE reverses. Steven Major, global head of fixed income research at HSBC, believes the interplay of QT and the hydraulics of the financial system is too complex to predict properly. “The truth is, no one really knows,” he says, including the Fed.

The last time QT was tried, under Fed Chair Janet Yellen, now Treasury secretary, it went perfectly—until suddenly it didn’t. Ms. Yellen said the predictable pace of balance sheet reduction from 2017 should be “like watching paint dry,” and it has been for two years. Then, in 2019, the overnight lending market — critical to the financial system and dependent on ample reserves — seized, forcing an emergency bailout to avoid a full-blown credit crisis.

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QT is a little different this time, the main reason Ruffer is so scared. Before we get into that, a quick reminder about central bank reserves for those who haven’t delved into the monetary system in a while. The Fed creates reserves as a special form of dollars that can only be held by banks and certain similar companies, which they use to settle debts to each other. (The rest of us mostly use electronic money created by banks, plus physical dollars.) Since QE began, reserves have increased as the Fed built up reserves to buy bonds from banks.

In contrast to 2017, large amounts of reserves have been returned to the central bank through money market funds. These funds, which savers use as a liquid alternative to savings accounts, are allowed to deposit money at the Fed overnight using reverse repurchase agreements (RRPs) and have already absorbed $2.2 trillion in reserves from the system, from scratch at the beginning. of last year.

For now, loss of reserves is not a problem. Banks had too many deposits and reserves anyway, and they still have $3.3 trillion in reserves, more than they ever had until last year. But there are risks.

Ruffer’s concern is that the loss of reserves will inhibit banks’ willingness to take risks. This doesn’t really matter when the markets are calm, but, to put it mildly, they aren’t. Ruffer expects widespread withdrawals by fund managers after their terrible year, forcing a selloff in stocks and bonds. If banks are tight and reluctant to use money, they will not reduce price cuts and markets could suddenly fall.

A more striking concern is that the loss of reserves in money market funds will drain banks so much that their reserve levels approach the minimum the Fed believes is necessary to avoid a repeat of the 2019 meltdown. Deutsche Bank strategist , Tim Wessel, argued in a recent note that the Fed will likely end QT when banks have $2.5 trillion in reserves.

If money market funds continue to grab deposits and park them with the Fed’s reverse repo facility, that could be reached as early as January, he says – forcing the Fed to an embarrassingly early end to QT. Alternatively, it could lower the interest rate it offers on money market funds to try to move money back into bank deposits.

Where this stops being unpleasant is that an early end to QT would mean higher interest rates would be needed for the Fed to tighten the same policy, which is sure to hit stocks.

The problem with these risks is that they are real, but it is impossible to tell if or when they will strike. I don’t have enough confidence that the problem is so imminent that investors need to put up a lot of cash like Ruffer. There are enough other issues – notably the market’s failure to prepare for weaker earnings next year – to keep me bearish on stocks, but inflation makes cash an expensive place to hide. However, QT is a risk to watch closely, because it’s only boring until it suddenly isn’t.

Write to James Mackintosh at james.mackintosh@wsj.com

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