US Fed shrinking balance sheet at a much slower pace than planned earlier

As a result, the yield 10-year US government bond is down 14 per cent in the last seven weeks while the S&P 500 up 11.3 per cent in the period

The stock market's worst fears of a "too" hawkish monetary stance by the US Federal Reserve has turned out to be unfounded. The American central bank is shrinking its balance sheet at a much slower pace than planned earlier which has kept the liquidity conditions in the market much more benign.  

The Fed balance sheet has shrunk by just $75.5 billion or 0.84 per cent from its peak in April this year. Early this year, the Federal Reserve announced a plan to shrink its balance sheet at a rate of $47 billion per month in the first three months beginning May this year and $95 billion per month subsequently.

The US central bank ended the month of July with assets worth $8889 billion, against a peak of $8965.5 billion on April 13, 2022. So the actual decline in Fed balance sheet has been less than half what it had announced earlier. 

A lower than expected contraction in the Fed balance sheet has moderated the decline in monetary base or the money supply in the US economy. This in turn has benefitted the bond market and asset prices. The yield on the benchmark 10-year US government bond is down nearly 14 per cent or 44 basis points in the last seven weeks while the S&P 500 equity index is up 11.3 per cent during the period.

Earlier there were fears that a combination of an interest rate hike by the Fed and planned cut in its balance sheet size would crush asset prices and lead to a sharp decline in dollar inflows into emerging markets.

At its current price, the 10-year US government bond has a yield of 2.78 per cent down from three-year high of 3,23 per cent on a weekly basis. There is an inverse relationship between bond yields and their prices. Yields fall when prices rise and vice versa.

The S&P 500 index on the other hand is currently trading at 4091 up from one and half year low of 3674.8 on June 17. (See the adjoining charts).

This had a corresponding effect on Indian financial markets. The benchmark Sensex is up nearly 14 per cent from its June low while the yield on 10-year government of India bond is down 36 basis points of nearly 5 per cent from June highs. One basis point is one-hundredth of a per cent.

"The decline in the Fed balance sheet has been much less than expected by market participants earlier this year. This has kept the liquidity condition benign and had a calming effect on the markets," says Dhananjay Sinha, head of Chief Economist and co-Head Institutional Equities at Systematix Group.

According to him, the Federal Reserve is leaning on rate hikes to bring down record high inflation in the USA rather than shrink its balance sheet at a faster pace that could adversely affect the money supply and liquidity in the markets.

A rate hike by the central bank largely increases the yields on short duration bonds while a decline in Fed balance sheet raises the yields on long-term bonds. The latter has a bigger impact on long-term assets such as equity and residential real estate.