“I don’t know if the Fed or anybody really understands the impact of QT yet,” Aidan Garrib, head of global macro strategy and research at Montreal-based PGM Global, said in a telephone interview.
The Fed, in fact, began slowly shrinking its balance sheet — a process known as quantitative tightening, or QT — earlier this year. Now it is speeding up the process, as planned, and it is making some market watchers nervous.
The lack of historical experience surrounding the process increases the level of uncertainty. Meanwhile, research increasingly crediting quantitative easing, or QE, with raising asset prices logically points to the potential for QT to do the opposite.
Since 2010, QE has explained about 50% of the movement in price-to-earnings multiples, Savita Subramanian, equity and quant strategist at Bank of America, said in a research note on Aug. 15 (see chart below).
BofA US Equity & Quant Strategy
“Based on the strong linear relationship between QE and S&P 500 returns from 2010 to 2019, QT through 2023 would translate into a 7 percentage point drop in the S&P 500 from here,” he wrote.
File: How much of the stock market rise is due to QE? Here is an estimate
In quantitative easing, a central bank creates credit that is used to buy securities on the open market. Long-dated bond purchases are intended to drive yields down, which appears to be boosting appetite for riskier assets as investors look elsewhere for higher returns. QE creates new reserves on bank balance sheets. The added cushion gives banks, which must hold reserves according to regulations, more leeway to borrow or finance trading activities from hedge funds and other financial market participants, further boosting market liquidity.
The way to think about the relationship between QE and stocks is to note that as central banks undertake QE, it raises expectations of future earnings. That, in turn, lowers the equity risk premium, which is the additional return investors demand to own risky stocks over safe Treasurys, PGM Global’s Garrib noted. Investors are willing to move further up the risk curve, he said, which explains the rise in non-earnings “dream stocks” and other highly speculative assets amid the QE deluge as the economy and stock market recover from the pandemic in 2021.
But with the economy recovering and inflation rising, the Fed began shrinking its balance sheet in June and is doubling the pace in September to a maximum rate of $95 billion a month. This will be accomplished by letting $60 billion in Treasuries and $35 billion in mortgage-backed securities come off the balance sheet without reinvestment. At this rate, the balance sheet could shrink by $1 trillion in a year.
The unwinding of the Fed’s balance sheet that began in 2017 after the economy recovered from the 2008-2009 crisis was supposed to be as exciting as “watching paint dry,” then-Fed Chair Janet Yellen said at the time. It was a sloppy affair until the fall of 2019, when the Fed had to inject cash into dysfunctional money markets. QE then continued in 2020 in response to the COVID-19 pandemic.
More economists and analysts are sounding the alarm about the possibility of a repeat of the liquidity crisis in 2019.
“If the past repeats itself, shrinking the central bank’s balance sheet is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet liabilities,” warned Raghuram Rajan, former governor of the Reserve Bank of India and former chief economist at the International Monetary Fund and other researchers in a paper presented at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming, last month.
Hedge fund giant Bridgewater Associates warned in June that QT was contributing to a “liquidity hole” in the bond market.
The slow pace of the recession so far and the compounding of the balance sheet reduction have dampened QT’s impact so far, but that is about to change, Garrib said.
He noted that QT is usually described in the context of the asset side of the Fed’s balance sheet, but it is the liability side that matters to financial markets. And so far, reductions in the Fed’s liabilities have been concentrated in the Treasury General Account, or TGA, which essentially functions as the government’s checking account.
This actually serves to improve market liquidity, he explained, as it means the government is spending money to pay for goods and services. It won’t last.
The Treasury plans to increase debt issuance in the coming months, which will boost the size of the TGA. The Fed will actively redeem interest-bearing bills when coupon maturities are insufficient to cover monthly balance sheet reductions as part of QT, Garrib said.
The Treasury will effectively take money out of the economy and put it into the government’s checking account – a net drag – as it issues more debt. This will put more pressure on the private sector to absorb these Treasuries, which means less money to put into other assets, he said.
The concern for stock market investors is that high inflation means the Fed won’t be able to spin on the penny as it has done during past periods of market stress, said Garrib, who argued that tightening by the Fed and other major central Banks could be setting up the stock market for a test of the June lows in a decline that could go “significantly below those levels.
The main takeaway, he said, is “don’t fight the Fed on the way up and don’t fight the Fed on the way down.”
Stocks closed higher on Friday, with the Dow Jones Industrial Average DJIA, +1.19% , the S&P 500 SPX, +1.53% and the Nasdaq Composite COMP, +2.11% posting three-week losses.
Next week’s highlight will likely come on Tuesday, with the release of the August consumer price index, which will be analyzed for signs that inflation is easing.
