Wall Street

A street sign, Wall Street, is seen outside New York Stock Exchange in New York City on Jan. 3, 2019.

NEW YORK (Reuters) — Wall Street banks are intensifying preparations for the Federal Reserve's withdrawal of pandemic stimulus to ensure they are able to handle spikes in market volatility, help clients manage their risks -- and score a profit.

With the Fed expected to formally announce on Wednesday that it will begin tapering its monthly bond purchases, sales and trading teams are hearing more from clients concerned about the ramifications for their portfolios and the longer-term implications of rising rates and higher inflation, several senior bankers said.

"This is the most important issue on their minds. People have to revamp their portfolios and hedge their risk," said the head of fixed income, currencies and commodities or FICC trading at one large global bank, speaking on the condition of anonymity.

The expected increase in volatility presents an opportunity for trading desks to profit by helping clients buy and sell securities, provided the spread between bids and offers doesn't become so stretched that it is impossible to make a market - a scenario bankers say is unlikely because the Fed has given plenty of warning of its intentions.

Nevertheless, in recent weeks banks have been running simulations to ensure their systems can handle spikes in volatility similar to 2013's 'taper tantrum,' when a similar but unexpected decision by the Fed sent markets into a frenzy, and to prepare for different market scenarios, according to three trading sources.

"No one wants to see dislocated markets. If that happens it's bad for clients and for the industry because volumes effectively dry up," one of the sources said.

While such contingency planning is not unusual around major events, it underscores the depth of concern on Wall Street about how markets will react when the Fed stops pumping liquidity into capital markets.

The U.S. Treasuries market is already experiencing liquidity challenges which could spill into other markets, Bank of America warned in a report on Monday.

The central bank has been buying up government-backed bonds since March 2020, adding $4 trillion to its balance sheet, as part of an emergency response to the Covid-19 pandemic.

The strategy was designed to stabilize financial markets and ensure companies and other borrowers had sufficient access to capital. It succeeded but also resulted in unprecedented levels of liquidity, helping equity and bond traders enjoy their most profitable period since the 2007-09 financial crisis and leading to record levels of acquisitions and stock market listings.

Senior bankers are now grappling with how markets will react when that stimulus is taken off the table and what that means for their institutions.

"Tapering by the Fed certainly has the potential to remove some of the 'frothiness' from the market," said Paul Colone, U.S.-based managing partner at Alantra, a global mid-market investment bank.

2013 redux

Most bankers, however, do not expect a repeat of 2013, when the Fed began withdrawing stimulus it had introduced as a result of the 2007-2009 global financial crisis.

Back then, volatility spiked as investors tried to get ahead of the Fed by dumping bonds, leading to a surge in government bond yields, and moved out of riskier assets like stocks.

This time, there should be enough volatility to boost trading volumes but not disrupt investment banking pipelines, bankers say. The process could actually encourage deal-making if it eases inflation and supply chain concerns.

"If tapering relieves some of the pressure of rising prices then that has the potential to benefit many businesses," said Colone.

Investors are looking at creative ways to profit from the volatility created by tapering and uncertainty over how quickly interest rate hikes will follow, according to several market participants.

"Smart traders on Wall Street use a lot of leverage to take advantage of these tensions or mis-pricings, said Matt Freund, co-chief investment officer at Calamos Investments.

Investors are piling into relative value trades, betting on whether tapering and future rate hikes by the Fed and other central banks will affect government bond yields more in some countries than others, one FICC trader said.

Others are studying the market reaction to the 2013 tapering to inform their strategies.

"The market always learns and adjusts," said Freund. "2013 is a lesson that's not going to be ignored."

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