What does Fed exit mean for equities?

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All analysts expect the FOMC to announce the first Fed funds target rate increase in more than nine years at its September 16-17 meeting.

However, as UBS analysts point out, rate hikes will only be the first step towards monetary policy normalization. Fed will also have to adjust substantially its balance sheet after the start of tightening.

UBS analysts consider that there are three potential problems with the Fed’s big balance sheet:

1) It is an impediment to the normal functioning of markets used by the Federal Reserve to set policy.

2) It stimulates growth and, as such, works against Fed actions to slow economic activity.

3) It requires the Fed to utilize a number of tools to offset its impact, complicating policy, particularly if these tools prove ineffective. Rates are not the only levers the Fed will need to use as it normalizes policy.

As UBS experts note, “the large balance sheet is not a short-term problem,” considering that even if the Federal Reserve allows all maturing holdings to roll off beginning in 2016, UBS estimates that “the balance sheet would not return to normal size until 2022.”

What does the exit mean for equities?

For UBS analysts, the start of Fed normalization is “likely to mark the start of the shift back to a higher volatility equity market regime,” considering its balance sheet size and the fact that no central bank has successfully escaped the zero-rate bound in modern financial history (see Japan, 1999-present).

The Fed and other global central banks have actively sought to suppress market volatility since 2008 through various innovative means of liquidity provisions, with the result being the narrowest trading range in decades for the S&P 500 in 2015, capping four years of exceptional “market calm.”

UBS-FED-TC

However, UBS Strategists Julian Emanuel and Omar Elangbawya conclude that a shift in monetary policy accompanied by a shift to a higher equity volatility regime does not presage an imminent end to the 6½-year bull market. Historically, the average time to a bull market peak following the first Fed rate hike has been two years and the average gain has been 33%