Quantitative monetary easing is credited with boosting 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 underestimate what happens when the tide goes out.
“I don’t know if the Fed or anybody 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 actually began slowly shrinking its balance sheet — a process known as quantitative easing, or QT — earlier this year. Now it is accelerating the process, as planned, and that is making some market watchers nervous.
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 points to the potential for QT to do the opposite.
Since 201[ads1]0, QE has explained about 50% of the movement in market price-to-earnings multiples, Savita Subramanian, equity and quant 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.
Archives: How much of the stock market 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-dated bonds are meant to drive down yields, which appears to increase appetite for riskier assets as investors look elsewhere for higher returns. QE creates new reserves on bank balance sheets. The extra cushion gives the banks, which must keep reserves in line with the regulations, more room to lend or to finance trading activity by hedge funds and other financial market players, which further increases market liquidity.
The way to think about the relationship between QE and stocks is to note that when central banks do 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 over safe Treasurys, noted PGM Global’s Garrib. Investors are willing to venture further out on the risk curve, he said, which explains the surge in non-earnings “dream stocks” and other highly speculative assets amid the QE deluge as the economy and stock market recovered from the pandemic in 2021.
But with the economy on the rise and inflation rising, the Fed began shrinking its balance sheet in June, doubling its pace in September to its maximum rate of $95 billion per month. This would be accomplished by allowing $60 billion of Treasurys and $35 billion in mortgage-backed securities to roll off the balance sheet without reinvestment. At that rate, the balance sheet could shrink by $1 trillion in a year.
The unwinding of the Fed’s balance sheet, which began in 2017 after the economy had long recovered from the 2008-2009 crisis, should be as exciting as “watching paint dry,” then-CEO Janet Yellen said at the time. It was a ho-hum affair until the fall of 2019, when the Fed had to inject cash into malfunctioning money markets. QE was then resumed in 2020 in response to the COVID-19 pandemic.
Several economists and analysts have sounded the alarm over the possibility of a repeat of the liquidity crisis in 2019.
“If the past repeats itself, the shrinking of the central bank’s balance sheet is unlikely to be an entirely benign process and will require close monitoring of the banking sector’s callable liabilities on and off the balance sheet,” warned Raghuram Rajan, former governor of the Reserve Bank of India and former chief economist at the International the 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 pace of unwinding so far and the composition of the balance sheet reduction has dampened the impact of QT so far, but that is going 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 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.
It has actually served to improve market liquidity, he explained, as it means the government has used 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 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 drag – as it issues more debt. That will 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 won’t have the ability to swing on a penny like it did 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 off the June lows in a fall 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 finished higher on Friday, with the Dow Jones Industrial Average DJIA,
S&P 500 SPX,
and Nasdaq Composite COMP,
snaps a three-week streak of weekly losses.
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 heading back down.