The Federal Reserve It is credited with acquiring trillions of dollars in bonds during the 2008 financial crisis and especially during the 2020 coronavirus pandemic, boosting stock market returns and boosting other speculative asset values. Investors and policymakers may be anticipating what will happen when the tide comes out.
“I don’t know that the Fed or anyone else really understands the impact of the QT,” Aidan Gharib, head of international macro strategy and research at Montreal-based PGM Global, said in a phone interview.
The Fed, in fact, began gradually reducing its balance sheet — a process known as quantitative tightening, or QT — earlier this year. It is now speeding up the process as planned, worrying some market watchers.
A lack of historical experience around the process is raising the level of uncertainty. Meanwhile, research that further praises quantitative easing, or QE, by raising asset prices shows the potential for QT to do the opposite.
In the year Since 2010, QE has explained about 50% of the movement in market price-to-earnings multiples, Savita Subramanian, equity and quantitative strategist at Bank of America, said in an Aug. 15 research note (see chart below).
BofA US Equity & Quant Strategy
“Based on the strong linear relationship between QE and the S&P 500 from 2010 to 2019, QT translates into a 7 percentage-point downside to the S&P 500 by 2023,” she wrote.
Record: How much has the stock market risen due to QE? Here’s a guess.
In quantitative easing, the central bank creates loans that can be used to buy securities on the open market. Long-term bond purchases are intended to drive down yields, increasing demand for riskier assets as investors look elsewhere for higher returns. QE creates new reserves on bank balance sheets. The added cushion gives banks more room to hold regulatory reserves, borrow or finance trades with hedge funds and other financial market participants, further enhancing market liquidity.
A way to think about the relationship between QE and stocks is that when central banks do QE, it raises future earnings expectations. That, in turn, lowers the equity risk premium, requiring more return investors hold in riskier stocks over safer Treasuries, according to PGM Global Garib. As the economy and stock market recover from the pandemic in 2021, it explains the increasing flood of QE into income-free “dream stocks” and other highly speculative assets.
However, with the economy recovering and inflation rising, the Fed began reducing its balance sheet in June and doubled the pace in September to a maximum of $95 billion per month. This would be accomplished by allowing $60 billion in Treasurys and $35 billion in mortgage-backed securities to leave the balance sheet without reinvestment. At that rate, the balance sheet could shrink by $1 trillion a year.
After a long recovery from the 2008-2009 crisis, the economy The Fed’s deleveraging that began in 2017 should have been as exciting as “watching a paint drought,” said then-Federal Reserve Chair Janet Yellen. In the year Until the end of 2019, it was a ho-hum affair when the Fed had to inject money into troubled financial markets. QE continues in 2020 in response to the Covid-19 pandemic.
More economists and analysts are sounding alarm bells that a repeat of 2019’s liquidity crisis is likely.
Raghuram Rajan, the bank’s former governor, said: “If the past is to be repeated, the decline in the central bank’s balance sheet may not be an entirely safe process and calls for careful monitoring of the banking sector’s off-balance sheet accounts.” The former chief economist of the Reserve Bank of India and the International Monetary Fund and other researchers presented at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming last month.
In June, hedge-fund giant Bridgewater Associates warned that QT was contributing to a “liquidity hole” in the bond market.
So far, a combination of slower downwind speeds and reduced balance sheets has delayed QT results so far, but that’s about to change, Gharib said.
QT is often defined in terms of assets on the federal balance sheet, but it is the liability side that is important to financial markets. And so far, federal debt reductions have focused on the Treasury General Account, or TGA, which effectively serves as the government’s checking account.
That is actually used to improve the flow of goods, which means that the government has been 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 increase the TGA rate. The Fed actively redeems T-bills if coupon maturities are insufficient to meet monthly balance sheet reductions such as QT, Garrib said.
It is effective because the Treasury takes money out of the economy and puts it into the government’s checking account – a net drag – adding more debt. That puts more pressure on the private sector to absorb those Treasurys, which means less money to put into other assets, he said.
Stock market investors worry high inflation means the Fed won’t be able to cut as much as it has during past periods of market stress, Gharib said, adding that the Fed and other major central banks may drop “significantly” from those levels to test the stock market’s lows in June.
The main takeaway, he said, is “don’t fight the feds on the streets and don’t fight the feds on the streets.”
On the Dow Jones Industrial Average, the DJIA, stocks rose on Friday.
S&P 500 SPX,
and Nasdaq Composite COMP,
A three-week run of weekly losses.
The highlight of the coming week could come on Tuesday, when the consumer price index for August is released, which will be analyzed for signs that inflation is easing back.