Quantitative monetary easing is credited with boosting stock market returns and boosting other speculative asset values by flooding markets with liquidity when the Federal Reserve purchased trillions of dollars in bonds during the 2008 financial crisis and pandemic of coronavirus of 2020 in particular. 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.
The Fed, in fact, began slowly shrinking its balance sheet, a process known as quantitative tightening, or QT, earlier this year. Now it is accelerating the process, as planned, and making some market watchers nervous.
The lack of historical experience around the process is raising the level of uncertainty. Meanwhile, research increasingly attributing rising asset prices to quantitative easing, or QE, logically points to the potential for QT to do the opposite.
Since 2010, QE has explained about 50% of the movement in market price-earnings multiples, Savita Subramanian, equity and quantification strategist at Bank of America, said in an Aug. 20 report. 15 research notes (see table below).
“Based on the strong linear relationship between QE and S&P 500 returns from 2010 to 2019, the QT through 2023 would translate to a 7 percentage point drop in the S&P 500 from here,” he wrote.
File, Archive: How much of the stock market’s 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-term bond purchases are aimed at lowering yields, which is seen as increasing appetite for risky assets as investors look elsewhere for higher yields. QE creates new reserves on bank balance sheets. The additional cushion gives banks, which are required to hold reserves under regulations, more room to lend or finance the trading activity of hedge funds and other financial market participants, further enhancing market liquidity.
The way to think about the relationship between QE and equities is to note that as central banks undertake QE, it increases expectations of future earnings. That, in turn, lowers the equity risk premium, which is the extra return investors demand to hold risky stocks rather than safe Treasuries, noted Garrib of PGM Global. Investors are willing to venture further up the risk curve, he said, which explains the surge in dead-end “dream stocks” and other highly speculative assets amid the QE flood as the economy and market values recover from the pandemic in 2021.
However, with the economy recovering and inflation rising, the Fed began shrinking its balance sheet in June and is doubling the pace in September to its maximum rate of $95 billion per month. This will be accomplished by letting $60 billion of Treasuries and $35 billion of mortgage-backed securities come off the balance sheet without reinvestment. At that rate, the balance sheet could shrink by a trillion dollars in a year.
The dismantling of the Fed’s balance sheet that began in 2017 after the economy had long recovered from the 2008-2009 crisis was supposed to be as exciting as “watching the paint dry,” the Fed said at the time. then Federal Reserve Chair Janet Yellen. It was a dull affair until the fall of 2019, when the Federal Reserve had to pump cash into malfunctioning money markets. QE then resumed in 2020 in response to the COVID-19 pandemic.
More economists and analysts have sounded alarm bells about the possibility of a repeat of the liquidity crisis of 2019.
“If the past repeats itself, central bank balance sheet reduction is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet liabilities,” he added. Raghuram Rajan warnedformer governor of the Reserve Bank of India and former chief economist of the International Monetary Fund, and other researchers in a paper presented at the annual Kansas City Fed 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 liquidation so far and the composition of the balance sheet drawdown have muted QT’s effect so far, but that is set 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 for financial markets. And so far, reductions in Fed liabilities have been concentrated in the Treasury General Account, or TGA, which effectively serves as the government’s checking account.
That actually served to improve market liquidity, he explained, as it means the government has been spending money to pay for goods and services. It will not 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 Treasury bills when coupon maturities are not sufficient to meet monthly drawdowns from its balance sheet as part of QT, Garrib said.
The Treasury will effectively take money out of the economy and into the government’s checking account—a net drag—as it issues more debt. That will put more pressure on the private sector to absorb those Treasuries, which means less money to invest in other assets, he said.
The concern for stock market investors is that high inflation means the Fed won’t have the ability to turn on a dime like it did during previous periods of market stress, Garrib said, who argued that Fed tightening Banks and other major central banks could set the stock market for a test of June lows in a drop that could go “significantly below” those levels.
The main takeaway, he said, is “don’t fight the Fed when it goes up and don’t fight the Fed when it goes down.”
Stocks closed higher on Friday, with the Dow Jones Industrial Average
and Nasdaq Composite
snapping a three-week losing weekly streak.
The highlight of next week will likely come on Tuesday, with the release of the consumer price index for August, which will be scrutinized for signs that inflation is making a comeback.
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