One of the most important – if not the most important – macro driver behind asset returns in the post‐crisis years is changing direction. 
Unwinding the Fed’s bloated $4.5trn balance sheet means the frequently cited ‘wall of liquidity’ will shrink, slowly at first, before gradually gathering pace to reach a ‘peak velocity’ of an annualised $600bn.
Money matters for markets, and as the liquidity regime changes, the market regime will likely change as well.
As was the case with QE I, II and III, the Fed’s balance sheet unwind is unprecedented. There are no textbook examples of how this will play out in the markets and the global economy.
Whether other return drivers will replace the wall of liquidity will be highly dependent on the market and macro reaction once quantitative tightening has been rolled out.
A reduction of the Fed’s balance sheet will only accelerate the net tightening of global liquidity conditions already in place.
This is even more the case if quantitative tightening results in a renewed strengthening of the US dollar, reducing the dollar value of other central bank balance sheets. As the world’s number one reserve currency, it is ultimately dollar liquidity that matters.
Investors must not be complacent
There is no reason to be complacent about the great unwind of QE. Complicating things further, inflation still is far below the Fed’s target. While the Fed admits it has no clue why, it still continues the tightening process.
Therefore, this episode differs from ‘normal’ tightening periods. Instead of inflation, financial stability concerns seem to be a key reason for the balance sheet reduction.
Although the Fed has a poor track record when it comes to asset price targeting, quantitative tightening makes sense in order to limit financial risks further down the road. But from a real economic perspective it also means that downside risks for the real economy might be higher than usual under Fed tightening periods.
However, given relatively robust economic momentum in the first half of 2017 and the usual time lag before inflation reacts to economic activity, the balance sheet unwind is a risk worth taking from a central bank perspective.
Although quantitative tightening carries significant risks, staying put with an unchanged balance sheet might be the riskiest of all strategies.
Heightened volatility on the way
Volatility has tended to increase around the time the Fed makes major adjustments in hawkish directions, so the Fed’s balance sheet unwind points towards higher volatility going forward.
As the ‘central bank put’ consequently weakens, investor confidence is expected to become more shaky and volatility should slowly creep higher.
This is already evident in the currency markets, where implied volatility has increased over the last couple of months.
Arguably, currencies are less ‘manipulated’ by unconventional monetary policy than other markets, which is why FX could be a first mover in a more volatile direction.
We should also keep an eye on markets that have benefitted the most from low volatility and liquidity abundance.
High yield bonds naturally spring into mind.
The interest rate hike conundrum
What about interest rates? Some opposing forces are at work here.
On the one hand, the Fed’s decision to stop reinvesting amounts from maturing bonds means less net demand for fixed income assets, driving yields higher. On the other hand, keep in mind that reduced liquidity growth means monetary tightening.
Tightening ultimately is deflationary, especially since it seems to be more driven by financial stability concerns rather than higher growth and inflation.
This effect points towards lower interest rates in the medium term. Also, the structural drivers behind low rates, such as an ageing labour force and high debt levels, are not going to fade anytime soon, which will keep a lid on interest rates.
The Fed’s balance sheet unwind is therefore unlikely to create sustained upward pressure on core government bond yields and the yield curve may be set to flatten further. In the very short term though, increasing hopes for bold tax cuts in the US might cause a short‐term spike in yields.
The limited potential of risk assets
As for equities, this asset class has strongly outperformed fixed income in periods of an expanding Fed balance sheet. Therefore, a reduction in the balance sheet should create headwinds for equities, especially for the parts of the market that benefitted the most from the liquidity flood.
We expect a less stable trajectory for equities and lower returns in the coming months. That being said, if the status quo prevails with growth staying resilient, the equity risk premia as such still seems attractive – relatively speaking.
Looking further ahead, we see limited potential in risk assets relative to safer asset classes from a risk‐reward perspective.
Granted, equities continue to look attractive relative to bonds. But valuation might be a dangerous market guide when structural shifts are taking place in the overall liquidity regime.
Witold Bahrke is senior macro strategist at Nordea Asset Management. The views expressed above are his own and should not be taken as investment advice.