A Fed shift from quantitative tightening to 'tinkering' will emerge as a new bull factor for the stock market in 2023, Bank of America says

• A Fed shift away from quantitative tightening could be the next bull factor for stocks in 2023, according to Bank of America.
• The Fed has started to reduce its near $9 trillion balance sheet at a clip of about $95 billion per month.
• But central banks are "petrified of market consequences of liquidity withdrawal," BofA said.

A new bull factor for the stock market could emerge in 2023 after the Federal Reserve shocked markets with aggressive interest rate hikes earlier this year, according to a Friday note from Bank of America.

While most investors pay attention to the Fed's ongoing rate hikes, behind the scenes the central bank is reducing its near $9 trillion balance sheet via $95 billion per month roll-offs of its treasury and mortgage debt.

But that move, combined with quickly rising interest rates, is sucking liquidity out of the global market and could spark a shift in the Fed's policy heading into next year, according to the note.

That's because central banks are "petrified of market consequences of liquidity withdrawal," BofA's investment strategist Michael Hartnett said.

Fear of deeper declines materializing in equity and fixed income markets is what could ultimately spark a Fed shift away from quantitative tightening and towards quantitative "tinkering," Hartnett said. And it's partly already happening.

The Fed is so far the only global central bank that is operating quantitative tightening, and yet already the Bank of England has had to flip back to quantitative easing and buy gilts, delaying its planned tightening actions amid the fiasco sparked by UK prime minister Liz Truss' failed tax cut plans.

Meanwhile the Bank of Japan has been forced to buy bonds this week as the Yen plunges to 32-year lows relative to the US dollar. Additionally, the European central bank is "considering but not yet committing to even passive quantitative tightening," Hartnett said.

A signal investors can monitor that would suggest the Fed is leaning towards a pause would be halt in the US dollar's march towards new highs, according to the note.

Any pivot from the Fed, whether it's in the form of a pause in further interest rate hikes, or a reduction or pause in its monthly balance sheet reductions, could be viewed positively by investors and lead to a sizable relief rally, but Hartnett still sees pain ahead before that happens, with the expectation that stocks will hit new lows soon.

That's because there has been no capitulation among investors and their relationship to stocks, with Hartnett observing more than $9 billion in flows to equities over the past week.

"Still no final capitulation in equity flows," Hartnett said. "We're bearish despite ubiquitous bear sentiment."