NEW YORK • Stocks and corporate bonds may be the surprise big losers once the United States Federal Reserve starts reducing its US$4.5 trillion (S$6.1 trillion) balance sheet.
A committee of investors and banks highlighted that outside risk in a presentation to US Treasury Department officials this month.
A week after that, strategists at Morgan Stanley separately warned that investors are underestimating the trouble that the Fed's plans could bring to corporate debt markets.
Stocks have gained 10 per cent this year, including dividends, while corporate bonds are up 4.8 per cent as of last Friday's close. Both Treasury debt and mortgage bonds, the securities most directly influenced by the Fed's plans to reinvest less money, have lagged the broader US bond market this year, although their returns tend to be more stable.
The threat to the stock and corporate bond markets underscores the bind that the Fed is in as it tries to scale down the extraordinary stimulus it gave the economy during and after the financial crisis. Its quantitative easing programme has more than quadrupled its debt holdings, and Fed policymakers plan to start slimming down those investments soon, now that the economy is on more solid ground.
But cutting back could hurt markets and, perhaps, the broader economy in ways that are hard to forecast. As the Fed contracts its balance sheet, "all we can do is hypothesise what the paths are because this is unprecedented", said Mr Joubeen Hurren, credit fund manager at Aviva Investors.
Companies' borrowing costs, for example, might rise by 1.35 percentage points relative to Treasuries, according to the committee's presentation to the Treasury, and those higher funding expenses could weigh on stocks. The European Central Bank is considering further dialling down its quantitative easing, which could add to the pressure.
US high-grade companies have already sold about US$1 trillion of bonds this year, and are on track to break last year's issuance record. Junk bond yields, at just 5.8 per cent, are near all-time lows. In stocks, US markets are close to record highs.