Market Extra: As Wall Street watches yields climb, a big question emerges: What is the ‘right size’ for the Federal Reserve’s balance sheet?

Dec Mullarkey, like other institutional investors, has been waiting on the chance to buy bargain assets.

But despite a turbulent start to 2022 for bonds, businesses, and growth and technology stocks, much still hinges on how aggressive the Federal Reserve ends up being as it works to engineer tighter financial conditions to battle inflation, without hurting the economy.

“Everyone is having a little bit of dry powder ready, thinking there’s going to be a little bit of volatility,” said Mullarkey, SLC Management’s managing director of investment strategic and asset allocation, in a phone interview.

The problem for many bargain hunters in the past two years has been that any pockets of volatility have been relatively short-lived.

Even the rate-sensitive Nasdaq Composite Index COMP, +1.41% was on pace for a second day of gains Tuesday, after briefly heading near correction territory a day earlier. All three major U.S. corporate bond exchange-traded funds LQD, +0.30% HYG, +0.47% JNK, +0.50% were up on the week Tuesday, according to FactSet, despite being the first thing debt investors often sell during bouts of turmoil.

Mullarkey attributed market resilience to ample liquidity provided by easy monetary policies in the past two years, strong earnings and improved balance sheets for American corporations.

The question now is: “Will the Fed unwind too quickly?” he said. “That’s an issue that’s flagged quite a bit.”

Key Words: ‘Tough sledding’ ahead for highflying inflation trades, says investor who called ’87 stock-market crash

Yields still low, stocks near records

The Fed kicked off the new year with a clear focus on tamping down inflation, including through a potentially quicker path to higher rates and a less heavy footprint in financial markets.

Fed Chair Powell on Tuesday said “it is time to move away from emergency policy settings to a more normal level,” in a confirmation hearing for his second term as head of the central bank.

While the first rate hike looks likely in March, Powell, in his testimony, also didn’t rule out the Fed selling assets as it looks to shrink its near $8.8 trillion balance sheet, instead saying “more clarity” on the topic is coming.

“With the Fed doing a taper that’s twice as fast in 2013, and a quick rate hike cycle, I think market participants were repricing risks because of that pivot,” said Jeff Schulze, investment strategist at ClearBridge Investments, in a phone interview.

The yield on the 10-year Treasury note TMUBMUSD10Y, 1.741% was near 1.75% Tuesday, after hitting a nearly 2-year high Monday as it neared 1.8%.

Even so, much disagreement remain around the path to the “new normal” in terms of rates, the economy and inflation, but also living — and working — with the coronavirus and new variants.

See: ‘Tough sledding’ ahead for highflying inflation trades, says investor who called ’87 stock-market crash

“We actually think inflation is likely to moderate by a year from now, falling back below 3%,” said Jay Willoughby, chief investment officer at TIFF Investment Management. “While we are negative on bonds, there’s the possibility that the Fed doesn’t have to do as much as it thinks, today.”

Rates not too high to borrow

Higher benchmark rates to kick off 2022 have yet to dent borrowing by major U.S. corporations.

BofA Global analysts estimate that $61 billion of U.S. investment-grade corporate bonds was issued in the year’s first week, the highest since the near $80 billion weekly deluge following Labor Day. They also are forecasting up to $40 billion more through Friday, despite the “recent hawkish repricing of the Fed.”

The team attributed the favorable credit conditions in part to investment-grade bond yields that still “remain attractive to foreign investors” after foreign-exchange hedging costs, and the unlikely event of a “rate shock leading to significant outflows.”

U.S. corporate bond yields also have been gradually climbing, ticking up from post-2008 lows of under 2% to top 2.5% in the months since August, when Powell signaled the central bank could soon start tapering its $120 billion in monthly bond purchases.

But a key to keeping the calm will be the Fed finding the right size of its balance sheet, particularly since it mushroomed to top $4 trillion the wake of the 2008 financial crisis, briefly dipped, but then kept growing to its current record size during the pandemic.

SLC’s Mullarkey said it isn’t clear what the ultimate size of the Fed’s balance sheet should be to support the market in its current form. “If you think about the actual liquidity the Fed needs to provide, they likely need to provide more than in the past, because liquidity can dry up quickly,” he said.

“But it almost seems like we need at least $4 trillion,” he said. “That’s going to be a big conversation.”

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