With the Federal Reserve capturing trillions of dollars in bonds during both the 2008 financial crisis and the 2020 coronavirus pandemic in particular, quantitative easing has been credited to flood markets with liquidity, boosting stock market returns and boosting other speculative asset values. Investors and policymakers may be underestimating what happens when the tide goes out.
“I don’t know if the Fed or anyone else really understands the impact of QT yet,” Aidan Garrib, head of global macro strategy and research at Montreal-based PGM Global, said in a phone interview.
In fact, the Fed began gradually shrinking its balance sheet earlier this year, a process known as quantitative tightening or QT. It is now accelerating the process as planned, making some market watchers nervous.
The lack of historical experience with the process raises the level of uncertainty. Meanwhile, research increasingly crediting quantitative easing, or QE, with rising asset prices, logically points to the potential for QT to do the opposite.
Since 2010, QE has accounted for about 50% of the movement in market price-earnings multiples, said Savita Subramanian, equity and quantitative strategist at Bank of America. 15 research notes (see table below).
BofA USA Stock and Quantity Strategy
“Based on the strong linear relationship between QE and S&P 500 returns from 2010 to 2019, from QT to 2023, that will translate into a 7 percentage point drop in the S&P 500 from there,” he wrote.
Archives: How much of the stock market rise is due to QE? here is a guess
In quantitative easing, a central bank creates credit that is used to purchase securities on the open market. Long-term bond purchases aim to lower yields, which appears to increase appetite for risky assets as investors look elsewhere for higher yields. QE creates new reserves on bank balance sheets. The added cushion further increases market liquidity by giving banks, which are required to hold reserves in accordance with regulations, more room to lend or finance trading activities by hedge funds and other financial market participants.
The way to think about the relationship between QE and stocks is to note that as central banks take on QE, it raises future earnings expectations. In turn, PGM Global’s Garrib said it lowered the equity risk premium, the extra return that investors demand to hold risky stocks on safe Treasuries. Investors said they were willing to move further down the risk curve, which explains the rise in unearned “dream stocks” and other highly speculative assets amid the QE flood as the economy and stock market recover from the pandemic in 2021.
However, with the economy recovering and inflation rising, the Fed began shrinking its balance sheet in June and doubled its pace in September to a monthly maximum of $95 billion. This will be done by allowing $60 billion of Treasury and $35 billion of mortgage-backed securities to be removed from the balance sheet without reinvestment. At this rate, the balance sheet could shrink by $1 trillion a year.
The easing of the Fed’s balance sheet, which began in 2017 after the economy recovered long after the 2008-2009 crisis, was supposed to be as exciting as “watching the paint dry” by then-Federal Reserve Chair Janet Yellen. It was a ho-hum thing until the fall of 2019, when the Fed had to inject cash into the coin markets. QE later resumed in 2020 in response to the COVID-19 pandemic.
More economists and analysts are ringing alarm bells about the possibility of a recurrence of the 2019 liquidity squeeze.
“If history repeats itself, shrinking the central bank’s balance sheet will likely not be a completely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet claimable liabilities.” Raghuram warns RajanThe former governor of the Reserve Bank of India and the former chief economist of the International Monetary Fund and other researchers wrote in an article 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 had contributed. and the “liquidity hole” in the bond market.
The combination of the slow pace of deceleration and the balance sheet reduction so far has dampened the impact of QT, but that’s poised to change, Garrib said.
He noted that QT is often defined in the context of the asset side of the Fed’s balance sheet, but it is the debt side that matters to financial markets. And so far, the reductions in Fed liabilities have been concentrated in the Treasury General Account, or NPL, which effectively serves as the government’s checking account.
Since this meant that the government was spending money to pay for goods and services, it actually served to improve market liquidity. It won’t last.
The Treasury plans to increase debt issuance in the coming months, which will increase the size of the NPL. Garrib said the Fed will actively use T-bills when coupon maturities are not sufficient to cover monthly balance sheet discounts as part of QT.
The treasury will effectively withdraw money from the economy and deposit it into the government’s checking account as it lends more money – a net drop. 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 will mean the Fed won’t have the ability to return on a dime as it has in past times of market stress, Garrib said, with tightening by the Fed and other major central bank banks in a decline that could fall “significantly below” these levels. They could set up the stock market to test June’s lows.
The main takeaway, he said, was, “Don’t fight the Fed going up and don’t fight the Fed going down.”
Stocks closed higher on Friday, with the Dow Jones Industrial Average
DJIA,
S&P 500
SPX,
and Nasdaq Composites
composition,
closing a three-week streak of one-week losses.
The highlight of the week ahead will take place on Tuesday, with the announcement of the consumer price index for August, which will be analyzed for signs of a pullback in inflation.
