Author：Cold Wind Meta

Author: Xiao Yanyan, Jinshi Data

Although the market seems to have already priced in another rate cut by the Federal Reserve, pushing U.S. stocks near record highs last Friday, the outcome of this week's Fed policy meeting will likely have a significant impact on the bull market for stocks and other risk assets.The real driving force may not come from interest rates..

“Right now, the interest rate side of monetary policy is undoubtedly restrictive, but that doesn’t seem to matter,” said Michael Kelly, global head of multi-asset management at PineBridge Investments, a global investment firm that manages $215.1 billion in assets.

At least judging from the performance of the S&P 500, the index is up 16.8% year-to-date, according to Dow Jones Market Data, and is poised for another strong year.

In Kelly's view,In reality, the United States has two types of monetary policy at work. One is balance sheet monetary policy, which targets the "wealthy" class and continuously enhances the "wealth effect," stimulating consumption and supporting the economy; the other is interest rate policy, which targets everyone else.

Kelly points out that high interest rates have already hurt small businesses that are laying off workers. In a K-shaped economy, lower-income families are also under pressure, while the situation for upper-income families can be said to have improved.

Recent credit card data tells a similar story. Grace Zwemmer, associate economist at Oxford Economics, wrote in a report last Friday that lower-income consumers are more likely to carry credit card debt and are more prone to reaching their credit limits. However, it is higher-income consumers, who are less likely to have credit card debt, who are driving consumer spending.

Kelly believes thatThese two economic realities make any comments from the Federal Reserve regarding its $6.5 trillion balance sheet crucial for the markets."Are they planning to maintain the size of their balance sheet, or will they begin to expand again?"

Despite a turbulent year and localized weakness during Trump’s second term, U.S. stocks appear poised to soon recover to record highs.

According to FactSet data, the S&P 500 has achieved an astonishing 73% increase over the past three years.

This boom stems from both market enthusiasm for the artificial intelligence theme and reflects the minimal dampening effect of the Federal Reserve's high interest rates on bullish sentiment in the stock market.

Equally important, credit spreads remain near historically low levels, suggesting that investors are not overly concerned about the looming risk of default.

Possible actions by the Federal Reserve

This favorable asset backdrop came after the Federal Reserve had already reduced its peak balance sheet of approximately $9 trillion during the pandemic by about $2.5 trillion. Subsequently, following pressure in the overnight funding markets, the Fed halted its balance sheet reduction on December 1.

This is important because the Federal Reserve has repeatedly stated publicly that it wants to avoid a repeat of the 2019 repo crisis. Bank of America Global's interest rate strategy team stated last Friday...They expect the Federal Reserve to announce this week that it will begin purchasing Treasury bills with maturities of one year or less at a rate of $45 billion per month starting in January as a "reserve management operation".

The report states that this will lead the Federal Reserve to purchase at least $20 billion in bonds per month to support the natural growth of its balance sheet, and an additional $25 billion in bonds to reverse the excessive outflow of reserves, at least for the first six months.

Others believe that this may take more time, and that the Federal Reserve will not need to take much action to keep the market running smoothly.

“From a broader perspective, as part of reserve management operations, the Federal Reserve will naturally begin purchasing Treasury bills next year, as it will naturally meet the expanding demand for reserves in the economy,” said Roger Hallam, global head of rates at Vanguard Fixed Income.

Harlem expects the Federal Reserve to begin purchasing Treasury bills at a rate of $15 billion to $20 billion per month by the end of the first quarter or the beginning of the second quarter of next year.

“This is a normal central bank reserve operation and does not contain any monetary policy signals. It’s just a normal business procedure that the Federal Reserve should follow to ensure system liquidity. This is to keep funding rates stable,” he said.

PineBridge's Kelly predicts that the Federal Reserve will cut interest rates by another 25 basis points on December 10, bringing the policy rate down to a range of 3.5%-3.75%, one step closer to the historical neutral rate of about 3% aimed at maintaining the smooth operation of the economy.

Despite market expectations of an impending rate cut, yields on longer-term U.S. Treasury bonds rose sharply over the past week. The 10-year Treasury yield touched 4.14%, suggesting that even with lower short-term rates, borrowing costs for households, businesses, and the U.S. government may remain high.

Kelly said he is “fairly optimistic” about most markets next year, even if central banks only talk about starting to expand their balance sheets in the new year to return to a more “normal liquidity” environment.

“I don’t understand why the Fed is so aggressive in expanding its balance sheet but so stingy with interest rate cuts. If it were me, I would do the opposite,” Kelly said.