Investors are worried about the Federal Reserve’s commitment to raising interest rates.
Bears worry that the Fed will keep increasing rates until it chokes the economy into recession.
This is a significant concern.
The Fed tends to keep rates high until the economy begins to contract.
Many analysts follow the “three steps and a stumble” rule.
Years ago, traders noticed that stocks sold off after the Fed raised rates three times.
Interest rates are the most visible part of the Fed’s policy.
But the Fed’s other tools include balance sheet reversal.
How the Fed Uses Balance Sheet Reversal
Since 2009, the Fed has increased its balance sheet by buying Treasurys and mortgage-backed securities (MBSs).
These purchases increased the bank’s balance sheet.
Over the past 13 years, it added about $4.5 trillion, and the balance sheet grew to $9 trillion.
That money fueled a bull market.
In June, the Fed started to reverse its balance sheet policy.
It let up to $30 billion in Treasurys and $17.5 billion in MBSs roll off its balance sheet.
This led to a drop in assets on the balance sheet, as shown in the chart below.
June Reversal in Fed Balance Sheet Policy Shows Drop in Assets
Source: Federal Reserve.
Starting in September, the Fed will double the amount of its balance sheet reductions.
Analysts expect this to continue for at least two years, leading to a reduction of $2.5 trillion.
What This Reversal Means for Stocks
The stock market peaked as the Fed stopped adding liquidity to the economy.
With tightening set to accelerate, bears are worried.
On the other hand, stock market bulls believe the Fed will blink before the policy causes a recession.
They are confident the Fed won’t accept higher unemployment resulting from higher interest rates.
Bottom line: We’ll know in time, but whether the Fed causes a recession or not, the current policy seems sure to sink the stock market.
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Michael Carr is the editor of True Options Masters, One Trade, Precision Profits and Market Leaders. He teaches technical analysis and quantitative technical analysis at the New York Institute of Finance. Follow him on Twitter @MichaelCarrGuru.