WOOD Flash - US and Europe macro: FED vs ECB: balance sheet surprises ahead

The worsening inflation picture has coerced the Fed into taking a more hawkish narrative, which has been reflected in tighter financial conditions. Crucially, in our view, the equity market remains sanguine. We believe the impact of balance sheet reductions should be material on equity valuations, however the market remains too optimistic and is not discounting its impact yet. This divergence may prompt the Fed to take an even more hawkish posture, in the shape of aggressive tightening, which could increase the risk of a recession materially. Accordingly, we introduce a hawkish scenario in this publication, with a terminal rate of 3.25% in 2023E, above our base of 2.75%, to capture the range of possibilities and assess its impact on the 10 year yield and the NYSE.
The ECB, on the other hand is facing the same inflation problem as the Fed, but remains bound by complexities which greatly limit its manoeuvrability. As a result, we believe that another round of TLTROs is plausible, and contemplate a hawkish scenario for 2023E, in the shape of a quicker move towards the nominal neutral range of 1.50%, or possibly a gradual run-off of its balance sheet.