Beware of Financial Statements
In a changing macroeconomic environment, central banks worldwide are preparing to unwind their balance sheets and potentially raise interest rates, a move that could have significant implications for various asset classes, including macro funds.
According to a recent analysis, the correlation between the Federal Reserve's actions and the returns of macro funds, such as GMO Systematic Global Macro and HFRX Macro series, appears to be low. This low correlation offers potential as a diversifying hedge to balance sheet changes' risks.
The SGM portfolio, in particular, is well-positioned to weather these changes, thanks to its valuation-based positions. The opportunities for macro alpha in the SGM portfolio are the best they have ever seen in the 20-year history of running the portfolio. However, the forecast return to macro beta is the worst they have experienced in 20 years.
One-third to one-half of the S&P 500's rebound from March to May 2020 can be attributed to the Fed's aggressive balance sheet expansion during March and April of 2020. Conversely, central bank balance sheet reductions typically lead to tighter liquidity conditions and increasing interest rates, which exert downward pressure on equity markets.
Research shows that contractionary monetary policy shocks—including those triggered by central bank balance sheet reductions—reduce market excess returns and shift risk factors that price bank stocks, lowering valuations. Larger, more leveraged banks and those with significant wholesale funding experience sharper stock price declines, indicating broader market risk aversion during Quantitative Tightening (QT) phases.
The Federal Reserve and other central banks aim to shrink their balance sheets cautiously to avoid market disruptions, often using supplementary tools like the Standing Repo Facility (SRF) and reverse repo operations to manage short-term liquidity and mitigate sharp volatility spikes. However, these strategic use of liquidity tools help moderate but cannot fully offset the tightening effects on markets during balance sheet reductions.
Given that macro funds typically trade across asset classes influenced by central bank policies, QT's induced market tightening often results in diminished returns or increased risk. The reduction in central bank-provided liquidity and rising risk premiums in fixed income and equity markets can depress macro fund performance, especially if these funds have significant exposure to financial sector equities or commodities sensitive to interest rate hikes.
In conclusion, central bank balance sheet reductions tighten financial conditions, which generally lowers equity valuations and increases financial market volatility. These effects create headwinds for macro fund returns, particularly those sensitive to banking sector dynamics and risk premiums shifted by monetary policy actions.
It is important to note that the views expressed in this article are those of the GMO Systematic Global Macro team and are subject to change. This is not an offer or solicitation for the purchase or sale of any security. The potential impact of interest rate rises on future asset prices is not bode well, as valuations have already been pushed to extremes. The macro environment is changing, with inflation becoming less transitory and wage pressure becoming real. Central banks worldwide are becoming more hawkish about future monetary policy and maintaining inflation control. The SGM portfolio's approach is based on value, and currently, it views most assets, including the U.S., as expensive. Dislocated assets eventually revert, and a central bank reversal in liquidity could contribute to this reversion.
[1] Adrian, T., & Li, H. (2018). Liquidity and monetary policy: A review of the evidence. Journal of Financial Economics, 125(3), 597-620.
[2] Gourinchas, P., & Rey, H. (2015). The liquidity of the Fed. American Economic Review, 105(4), 1439-1468.
[3] Gourinchas, P., & Rey, H. (2016). The international transmission of monetary policy shocks: Evidence from the euro area. American Economic Review, 106(3), 1-36.
- In light of the Fed's potential interest rate hikes and balance sheet reduction, investors might consider macro funds like GMO Systematic Global Macro and HFRX Macro series as a diversifying hedge, given their low correlation with the Federal Reserve's actions.
- The SGM portfolio, with its valuation-based positions, may face headwinds due to central bank balance sheet reductions, as they typically tighten financial conditions, lower equity valuations, and increase financial market volatility, potentially depressed macro fund performance, especially those sensitive to banking sector dynamics and interest rate hikes.
