Quantitative easing has been credited with generating returns in the stock market and boosting the value of other speculative assets by flooding markets with liquidity, as the Federal Reserve raised trillions of dollars in bonds during the 2008 financial crisis and the coronavirus pandemic in particular. Investors and policy makers may underestimate what happens when the tide recedes.
“I don’t know if the Fed or anyone else really understands the impact of QT right now,” Aidan Grip, head of global macro strategy and research at PGM Global based in Montreal, said in a phone interview.
Indeed, earlier this year the Fed began slowly shrinking its balance sheet — a process known as quantitative tightening, or QT. Now the process is accelerating, as planned, which worries some market viewers.
The lack of historical experience in this process increases uncertainty. Meanwhile, research is increasingly relying on quantitative easing or quantitative easing, while giving asset prices a logical boost suggests that Qt could do the opposite.
Since 2010, QE has accounted for about 50% of the movement in market price-earnings ratios, Savita Subramanian, equities and quantitative analyst at Bank of America, said in a research note on August 15 (see chart below).
“Based on the strong linear relationship between QE and the S&P 500 from 2010 to 2019, QT through 2023 would translate into a 7 percentage point decline in the S&P 500 from here,” she wrote.
Archives: How high has the stock market risen as a result of quantitative easing? This is an estimate
In quantitative easing, the central bank creates credit which is used to purchase securities in the open market. Long-term bond purchases aim to lower yields, which appears to increase interest in risky assets as investors look elsewhere for higher returns. Quantitative easing creates new reserves in banks’ balance sheets. The extra cushion gives banks, which are required by regulations to hold reserves, more room to lend or finance trading activities through hedge funds and other financial market participants, thus increasing market liquidity.
The way to think about the relationship between quantitative easing and stocks is to note that the way central banks do quantitative easing raises expectations of future earnings. This, in turn, reduces the equity risk premium, the additional return that investors need to hold risky stocks in safe treasuries, as noted by PGM Global’s Grape. He said investors are ready to ramp up the risk curve, explaining the surge in dividend-free “dream stocks” and other highly speculative assets amid the flow of quantitative easing as the economy and stock market recover from the 2021 pandemic.
However, with the economy recovering and inflation rising, the Fed began shrinking its balance sheet in June, doubling the pace in September to a maximum rate of $95 billion per month. This will be achieved by allowing $60 billion of government bonds and $35 billion of mortgage-backed bonds to trade on the balance sheet without reinvestment. At this rate, the balance sheet could shrink by a trillion dollars annually.
Then-Fed Chair Janet Yellen said the Fed’s balance sheet solution, which began in 2017 after the economy had long recovered from the 2008-2009 crisis, should be as exciting as “watching the paint dry.” It was tough until the fall of 2019, when the Federal Reserve had to pump money into the crippled money markets. Then QE resumed in 2020 in response to the COVID-19 pandemic.
More and more economists and analysts are sounding the alarm about the possibility of a repeat of the 2019 liquidity crisis.
“If the past repeats itself, then downsizing the central bank’s balance sheet is unlikely to be a wholly benign process and close monitoring of obligations on and off the balance sheet of the banking sector is unlikely.” Raghuram, a former Rajandhi governor of the Reserve Bank of India and former chief economist of the International Monetary Fund, and other researchers warned in a paper presented last month at the Federal Reserve’s annual symposium in Kansas City in Jackson Hole, Wyoming.
Hedge fund giant Bridgewater Associates warned in June that QT is contributing to: the liquidity gap in the bond market.
The slow cooling rate to date and the composition of the balance sheet cut has softened the impact of QT so far, Gribb said, but that will change.
He noted that QT is usually described in the context of the assets side of the Federal Reserve’s balance sheet, but the liability aspect is important to financial markets. So far, the reductions in the Fed’s liabilities have been concentrated in the Treasury General Account, or TGA, which essentially serves as the government’s current account.
He explained that this actually improved market liquidity because it meant the government was spending money to pay for goods and services. will not last.
The Treasury Department plans to increase debt issuance in the coming months, which will increase the size of the TGA. Grip said the Fed will actually repay Treasuries when the coupon maturities are insufficient to meet monthly balance sheet cuts as part of the QT.
The Treasury will effectively pull money out of the economy and put it in the government’s current account – a net drawback – as it spends more debt. That would put more pressure on the private sector to absorb those coffers, he said, which means less money to put into other assets.
The concern of stock market investors is that high inflation means that the Fed will not be able to operate with a single currency as it did during previous periods of market stress, Gripp said, noting that tightening by the Fed and other major central banks could By preparing the stock market to test its June lows in the event of a decline “significantly below” those levels.
The main takeaway, he said, is “Don’t fight the Fed on the way up and not the Fed on the way down.”
Stocks closed higher on Friday, with the Dow Jones Industrial Average,
S&P 500 SPX,
After three weeks of weekly losses.
Next week’s high is likely to come on Tuesday, with the release of the August CPI, which will be analyzed for signs of easing inflation.