Quantitative monetary easing is credited with draining stock market returns and boosting other speculative asset values by flooding markets with liquidity as the Federal Reserve snapped up trillions of dollars in bonds during both the 2008 financial crisis and especially the 2020 coronavirus pandemic. Investors and policymakers may be underestimating what happens when the tide goes out.
“I don’t know if the Fed or anybody else really understands the impact of QT,” Aidan Garrib, head of global macro strategy and research at PGM Global in Montreal, said in a telephone interview.
In fact, the Fed began slowly shrinking its balance sheet earlier this year — a process known as quantitative easing, or QT. Now it’s speeding up the process, as planned, and that’s making some market watchers nervous.
A lack of historical experience around the process increases the uncertainty level. Meanwhile, research increasingly allowing quantitative easing, or QE, to give asset prices a boost logically points to the potential for QT to do the opposite.
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).
“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,” she wrote.
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. Purchases of long-term bonds are intended to drive down yields, increasing the appetite for risky assets as investors look elsewhere for higher returns. QE creates new reserves on bank balance sheets. The additional cushion gives banks, which must hold reserves in accordance with regulations, more room to lend or to finance trading activities by hedge funds and other financial market participants, further improving market liquidity.
The way to think about the relationship between QE and stocks is to note that as central banks undertake QE, it raises expected earnings. That, in turn, lowers the equity risk premium, which is the extra return investors demand for holding risky stocks over safe Treasurys, PGM Global’s Garrib noted. Investors are willing to venture further up the risk curve, he said, explaining the surge in earnings-free “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, doubling the pace in September to its maximum rate of $95 billion per month. This will be achieved by rolling $60 billion of Treasurys and $35 billion of mortgage-backed securities off the balance sheet without reinvestment. At that pace, 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 2008-2009 crisis was supposed to be as exciting as “watching paint dry,” said Janet Yellen, then-Fed. Reserve chairman, said at the time. It was a ho-hum affair until the fall of 2019, when the Fed had to inject cash into dysfunctional 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 2019 liquidity crisis.
“If the past repeats itself, shrinking the central bank’s balance sheet is unlikely to be an entirely benign process and will require close monitoring of the banking sector’s on- and off-balance sheet callable liabilities,” said 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 last month at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming.
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 wind-down so far and the compounding of the balance sheet reduction has dampened the effect of QT so far, but that will 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 Fed liabilities have been concentrated in the Treasury General Account, or TGA, which effectively serves as the government’s checking account.
This actually served to improve market liquidity, he explained, as it meant the government was spending money to pay for goods and services. It won’t last.
The Treasury plans to increase debt issuance in coming months, which will increase the size of the TGA. The Fed will actively redeem T-bills when coupon maturities are insufficient to meet their 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 brake – as it issues more debt. That would put more pressure on the private sector to absorb those treasuries, meaning less money to put into other assets, he said.
The concern for stock market investors is that high inflation means the Fed will not have the ability to turn on a dime as it has in previous periods of market stress, said Garrib, who argued that the 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 key takeaway, he said, is “don’t fight the Fed on the way up and don’t fight the Fed on the way down.”
Stocks ended higher on Friday, with the Dow Jones Industrial Average DJIA,
S&P 500 SPX,
and Nasdaq Composite COMP,
recording a three-week weekly losing streak.
The highlight of the week ahead is likely to come on Tuesday, with the release of the August consumer price index, which will be analyzed for signs that inflation is on the way again.