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US markets are like a 'self-propelled car with a rusty chassis,' expert says

Key Points
  • Analyst tells CNBC that the market is failing to understand the impact of the Federal Reserve unwinding its balance sheet.
  • Hans Redeker also likened the U.S. stock market to a "self-propelled car" that didn't have much further to run.
  • The Fed currently has more than $4.2 trillion worth of assets on its books.
A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, Aug. 19, 2016. U.S. stocks slipped for the first time in three days, with a recent rally showing signs of tiring amid elevated valuations and speculation over the potential timing of higher borrowing costs.

U.S. markets are too complacent about rising interest rates and "quantitative tightening," an expert told CNBC on Tuesday.

This complacency comes as the Federal Reserve looks to unwind its balance sheet of several trillion dollars' worth of treasury and mortgage-backed securities and markets, Hans Redeker, global head of FX Strategy at Morgan Stanley, said.

"The Fed is, from October, going to absorb $600 billion (of securities on its balance sheet) on an annualized basis, (interest) rates are going up, and I think in the market there is too much debate about rates and not the combined effect (of these events)," Redeker said.

"At the end of the day we're in an environment of quantitative tightening plus higher interest rates and is that really what the market is currently pricing? I doubt that," he added.

Redeker likened the U.S. stock market to a "self-propelled car" that didn't have much further to run. "It currently looks like we are, in respect to the U.S. market, like a self-propelled car with a rusty chassis," he said.

When the financial crisis struck the U.S. economy in late 2007, the Federal Reserve lowered interest rates and embarked on a series of quantitative easing (QE) programs designed to lower corporate and government borrowing costs and boost lending and spending — with the aim of enabling the economy to recover.

The Fed injected liquidity into the economy by purchasing masses of U.S. Treasuries — government bonds — and mortgage-backed securities. In the process, its balance sheet ballooned from around $800 billion to the current level of around $4.2 trillion.

A decade on and the U.S. economy is well into its recovery; the central bank announced in September 2017 that it was ending QE and would start "normalizing" its balance sheet. Earlier, in late 2015, it made its first interest rate rise in seven years. In the last year, rates have steadily increased (its benchmark short-term interest rate increased to 1.75 percent to 2 percent in June) and the bank has slowly and gradually shed the mass of securities it purchased as it normalizes its extraordinary monetary policy. The process of "quantitative tightening" means the Fed is allowing securities to mature without replacing them.

I think the Fed is doing it wrong and should sell its treasuries, says Jim Cramer

This so-called "unwinding" of its balance sheet matters for investors because much of the liquidity created by the central bank ended up in stock markets as investors looked for better returns amid a low interest rate environment.

There are concerns, however, that QE has led to artificially inflated asset prices and overheated stock markets, hence Redeker's comments likening U.S. markets to a rusty, self-propelled car.

Redeker is not alone in such worries, with fears of a market panic or inflation widespread.

In July, Jamie Dimon, the chairman and chief executive officer of J.P. Morgan Chase, said that one of the biggest risks to the U.S. economy is the reversal of the extraordinary measures could backfire and cause a market panic. And former Treasury Secretary Larry Summers said in mid-2017 that the reversing of QE needed to be carried out with "great care" in order to prevent inflation from rising as liquidity is withdrawn.