- The Fed has ratcheted up interest rates this year, but that’s only half of its approach to combat inflation and taming frothy markets.
- Quantitative tightening is intended to suck excess liquidity from the market, fighting inflation and deflating the bubble.
- Experts say there is a potential that it goes too far, but the Fed can avoid the crisis if it eases up on QT gradually.
Inflation has weighed on markets all year, with the Fed hiking rates by more than 300bp in an effort to rein in sky-high prices.
Aggressive and historic rate hikes are only half of the approach, and there are other tools that central banks have used recently to help reduce inflation and reduce market bubbles that have formed as a result of easy monetary policy.
Unfortunately for investors, the tool is also set to weigh on the stock and bond markets, even more so than the Fed’s rate hikes. This massive change in liquidity conditions has fueled fears that quantitative tightening — the Fed’s $9 trillion balance sheet flow — could end in a market crash.
Here’s how two experts explain the Fed’s QT regime, and why it’s a fine balancing act between fighting inflation and keeping markets afloat.
What is quantitative tightening and what does it mean to reduce liquidity?
When the Fed conducts quantitative tightening, it reduces the size of its balance sheet. They are assets collected by the central bank, such as long-term government bonds, that eventually mature and allow the Fed to get the principal on those bonds. Once they see, the Fed can either reinvest the money, or can reduce the size of its balance sheet by simply letting the bonds “run away”. During quantitative tightening, the Fed chose not to reinvest.
This is quite different than if the Fed were actually selling bonds on its balance sheet into the market, but it has a similar effect of pushing rates higher.
The Fed shaved about $95 billion of Treasury bonds and mortgage-backed securities off its balance sheet a month. Essentially, it lowers the demand for long-term bonds, causing long-term interest rates to rise significantly.
What is the effect of QT?
The Fed hopes it can help reduce inflation. When real long-term interest rates increase, it lowers asset prices, causing inflation to slow. Higher rates also encourage households to save more, discouraging the type of consumption or investment that overheats the economy and stimulates inflation.
Does it affect stocks?
Similar to high interest rates, which can eat into the company’s profitability and depress the stock price, QT can have a negative effect on equities.
Remember, QT drains liquidity from the market by removing guaranteed buyers from massive amounts of debt securities. Removing so much liquidity from the market is sure to have a cascading effect, and bubbles like the meme-stock craze that gripped the market during the pandemic will deflate.
According to Amir Kermani, an economist at UC Berkley, this is also because when long-term interest rates for bonds rise, investors will want to move from stocks to long-term bonds.
So, no more stock memes?
Taken together, quantitative tightening and interest rate hikes will put a lid on meme stocks and asset speculation in general, RBA analyst Michael Contopoulos told Insider.
But it’s also not just about quantitative tightening.
“It would be too simple to just boil it down,” Contopoulos said. He pointed out that much of the pandemic-era stimulus money has gone out of savings, which was a major driver of the stock’s gains. Fed rate hikes have also dampened appetite for stocks this year by raising short-term interest rates.
With three-month government-guaranteed Treasuries yielding as high as 4%, why risk money in a stock market that is down 20% year-to-date?
When will QT end?
The quantitative tightening regime cannot last forever, Kermani said, and it is possible that the Fed will need to start slowing the rate of reducing its balance sheet. It is largely because the money coming off the balance sheet has mostly come from excess reserves, which are used by banks to meet liquidity needs.
Kermani estimates that the financial system may not be able to tolerate the excess reserves of banks’ dipping below $ 2 trillion, which may lead the Fed to stop QT sometime late 2023. He added that although the Fed will likely wait for a clear sign of inflation rolling over before. slowing the pace of quantitative tightening.
Why stocks rally after QT ends?
There is hope for a 2023 bull runAccording to Bank of America, which says even a shift from quantitative tightening to “tinkering” will stimulate stocks.
Whereas, other experts have their doubts for the tailwinds provided by the end of QT.
“Quantitative easing will have a temporary effect,” Contopoulos said. “Our research shows that the profit recession is just beginning and will peak into 2023.”
He noted that stocks are largely affected by the Fed “popping liquidity bubble” in the first six to nine months of this year, but the Fed’s policy will have a small impact on stocks later as the market shifts focus to corporate earnings.
“I think the next leg of the race down in stock prices is going to be driven more by the lack of earnings growth than it is going to be by what the Fed does.”
Is it possible for the Fed to screw this up?
Kermani says that quantitative tightening will not necessarily lead to a crash in stock prices – as long as the Fed reduces its portfolio gradually. But he thinks it would be a mistake to suddenly stop the quantitative tightening process at this point.
“It’s a big mistake for the Federal Reserve to change their mind because of the fear of what will happen to stock prices. We don’t want to live in a world where the Fed is responsible for stock market insurance. So I think some gradual adjustment of market prices is actually not bad,” he said.