As quantitative easing reverses, small declines in Treasury prices could potentially lower investors’ tolerance for risk, leading to a bigger drop in corporate bond prices and stocks, Cummins said.
“In an adverse scenario, there’s the possibility of a meaningful, but not systemically risky, decline in both credit and equities.” Cummins wrote in the Aug. 2 letter.
The committee’s presentation characterized declines in risk assets as a “financial engineering shock.” The group, whose members include JPMorgan Chase & Co., Goldman Sachs & Co., Citadel LLC and Pacific Investment Management Co., saw that scenario as a “tail risk,” meaning it is possible but not probable.
‘Feedback Loop’
Former Fed governor Jeremy Stein doubted that the central bank’s balance sheet unwind on its own would trigger a big sell-off in corporate bonds. Cutting back on quantitative easing is designed to be a gradual process. But the securities’ low risk premiums, or credit spreads, are still a concern, he said.
“When credit spreads are unusually narrow -- as they are now -- that can be worrisome,” said Stein, now a professor at Harvard University. Generally, that scenario is followed by widening spreads, credit contracting, and economic growth slowing, he said.
The growth of exchange-traded funds and mutual funds tied to corporate bonds could amplify pain in the market for company debt, Stein said. When trouble comes, retail investors are more likely to bail out, sending prices even lower. The Bank of England highlighted that same concern in a paper last month. Writing in the forward of the report, BOE executive director for financial stability Alex Brazier warned of a “feedback loop” between corporate bond price falls, fund redemptions and asset sales.
At some point, markets will test the Fed’s determination to continue withdrawing stimulus, Morgan Stanley strategists led by Adam Richmond wrote in an Aug. 9 note to clients.
“We think investors underestimated the tailwind from QE in this bull market, and they are similarly now underestimating the headwind from reverse QE,” the strategists wrote.
This article was provided by Bloomberg News.