Why ‘quantitative tightening’ is the wild card that could sink the stock market

Quantitative monetary easing is credited with boosting stock returns and boosting other speculative asset values ​​by flooding markets with liquidity as the Federal Reserve clawed back billions of dollars worth of bonds during the crisis financial crisis of 2008 and the coronavirus pandemic 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 right now,” said Aidan Garrib, head of global macro strategy and research at Montreal-based PGM Global. , 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’s speeding up the process, as expected, and it’s making some market watchers nervous.

A lack of historical experience around the process increases the level of uncertainty. Meanwhile, research that increasingly credits quantitative easing, or QE, with boosting asset prices logically indicates that QT could be doing the opposite.

Since 2010, QE has explained about 50% of the evolution of market price-earnings multiples, said Savita Subramanian, equity and quantitative strategist at Bank of America, in an Aug. 15 research note (see chart below). ).

BofA US Equities and Quantitative Strategy

“Based on the strong linear relationship between QE and S&P 500 returns from 2010 to 2019, QT through 2023 would translate to a 7 percentage point decline in the S&P 500 from here,” a- she writes.

Archive: How much of the rise in the stock market 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 depressing yields, which appears to be bolstering appetite for risky assets as investors look elsewhere for higher yields. QE creates new reserves on banks’ balance sheets. The additional cushion gives banks, which must hold reserves by regulation, more room to lend or finance the trading activity of hedge funds and other financial market participants, further improving market liquidity.

The way to think about the relationship between QE and equities is to note that when central banks undertake QE, it raises expectations of future earnings. That, in turn, lowers the equity risk premium, which is the extra return investors demand for holding risky stocks relative to safe Treasuries, noted PGM Global’s Garrib. Investors are ready to venture further down the risk curve, he said, which explains the surge in earnings-less ‘dream stocks’ and other highly speculative assets amid the QE flood. as the economy and stock market recovered from the pandemic in 2021.

However, with the economy picking up and inflation rising, the Fed began trimming its balance sheet in June and doubled the pace in September to its peak rate of $95 billion a month. This will be accomplished by letting $60 billion in treasury bills and $35 billion in mortgage-backed securities leave 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 had long recovered from the 2008-09 crisis was meant to be as exciting as “watching the paint dry,” Janet Yellen said at the time. then chair of the Federal Reserve. It was ho-hum business until the fall of 2019, when the Fed had to inject liquidity into dysfunctional money markets. QE then resumed in 2020 in response to the COVID-19 pandemic.

More and more economists and analysts have sounded the alarm over the possibility of a repeat of the 2019 liquidity crisis.

“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 liabilities on and off balance sheet,” warned Raghuram Rajan, former Governor of the Bank. Reserve Bank of India and former chief economist of 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 liquidation so far and the composition of the balance sheet reduction have so far mitigated the effect of QT, but that should change, Garrib said.

He noted that QT is usually described in the context of the active side of the Fed’s balance sheet, but it’s the passive side that matters to financial markets. And so far, the Fed’s liability cuts have been concentrated in the Treasury’s General Account, or TGA, which effectively serves as the government’s current account.

This actually served to improve market liquidity, he explained, because it meant the government spent 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 size of the TGA. The Fed will actively buy Treasuries when coupon maturities are not sufficient to meet their monthly balance sheet reductions under QT, Garrib said.

The Treasury will effectively take money out of the economy and put it into the government’s current 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 invest in other assets, he said.

Stock investors’ concern is that high inflation means the Fed won’t have the ability to pivot on short notice like it has done in recent periods of market stress, Garrib said, who argued that tightening by the Fed and other major central banks could set the stock market up 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 going up and don’t fight the Fed going down.”

Stocks ended higher on Friday, with the Dow Jones Industrial Average DJIA,
+1.19%,
S&P 500 SPX,
+1.53%
and Nasdaq Composite COMP,
+2.11%
snap a three-week streak of weekly losses.

The highlight of the coming week is likely to come on Tuesday, with the release of August’s consumer price index, which will be monitored for signs that inflation is coming down.

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