Sperandeo warns Fed's $6.7T balance sheet is AI market's blind spot

The Federal Reserve's $6.7 trillion balance sheet poses a greater risk to the AI-driven stock market than interest rate policy, according to Victor Sperandeo, the veteran trader who predicted the 1987 crash. While markets obsess over whether the Fed will cut the federal funds rate — currently held at 4.25 percent to 4.5 percent, unchanged since December — Sperandeo argues that quantitative tightening represents a far more consequential blind spot.

"Rate cuts lower the cost of capital, but they do not guarantee easier access to money," Sperandeo said. "The market is focused on the interest rate lever while underestimating the liquidity lever."

The distinction carries weight as the Fed's balance sheet stands at $6.7 trillion, down from a peak of nearly $9 trillion in mid-2022 but still more than double its pre-pandemic level. Reserves held by commercial banks — the component most directly affected by asset reductions — make up about 45 percent of the Fed's liabilities, or roughly $3 trillion. The central bank has been allowing up to $60 billion in Treasury securities and $35 billion in mortgage-backed securities to roll off its balance sheet each month, though it slowed the pace in 2024 to avoid repeating the liquidity crunch of September 2019.

For AI stocks trading at elevated multiples, a liquidity squeeze could trigger a sharp revaluation. The Nasdaq 100, which has more than doubled since the start of 2023 on the back of AI enthusiasm, is particularly exposed to shifts in financial conditions that extend beyond the fed funds rate. "If the Fed continues shrinking its balance sheet while the market expects rate cuts, the disconnect between liquidity and valuation becomes dangerous," Sperandeo said.

The 2019 Precedent

The September 2019 repo crisis shows how quickly abundant reserves can vanish. That month, a confluence of corporate tax payments and a large Treasury auction settlement drained reserves from about $1.6 trillion to $1.4 trillion, pushing overnight repo rates above 10 percent. The Fed was forced to intervene with emergency repo operations and later resumed balance sheet expansion. The episode left a lasting imprint on policymakers: Fed Governor Christopher Waller has said reserves below 9 percent of GDP — roughly $2.7 trillion at current levels — represent a critical threshold. The last time the Fed allowed reserves to approach that level, in September 2019, the S&P 500 fell 3 percent over the following two weeks while the 2-year Treasury yield dropped 25 basis points.

Warsh Takes the Helm

New Fed Chair Kevin Warsh, who presides over his first Federal Open Market Committee meeting this week, has signaled a desire for a smaller balance sheet. As a governor in 2010, Warsh was deeply skeptical of quantitative easing, calling it an "experiment" that disproportionately benefited large financial institutions. His first public remarks as chair, expected after the June FOMC meeting, will be scrutinized for clues on how aggressively he plans to pursue balance sheet reduction.

The challenge is that the Fed's two policy tools — the fed funds rate and the balance sheet — are moving in potentially conflicting directions. While futures markets price virtually no chance of a rate cut at the June meeting, with inflation running at roughly double the Fed's 2 percent target, the balance sheet continues to shrink. This creates what Sperandeo describes as a policy mix where the cost of money stays high while the supply of money tightens further.

For the AI sector, which has attracted enormous capital flows on expectations of a productivity revolution, the implications are direct. Many of the companies driving the rally — from chipmakers such as Nvidia to cloud infrastructure providers — rely on cheap financing for massive capital expenditure programs. A liquidity environment that tightens faster than rates suggest could raise funding costs and compress the valuation multiples that have propelled the market higher.

The Fed's Standing Repo Facility, established after the 2019 crisis, provides a backstop against acute liquidity stress. But banks have been reluctant to use it, fearing supervisory stigma. Darrell Duffie, a finance professor at Stanford University, has said the facility needs further reform to function as an effective safety valve. Until then, the risk of a liquidity event — and its disproportionate impact on richly valued assets — remains the market's most underappreciated policy risk.

This article is for informational purposes only and does not constitute investment advice.