Why this Fed move could be the ‘wild card’ flooding the stock market

In fact, the Fed began slowly shrinking its balance sheet — a process known as quantitative tightening, or QT — earlier this year. Now the process is speeding up, as planned, which makes some market watchers worried.

The lack of historical experience about the process raises the level of uncertainty. Meanwhile, research increasingly relies on quantitative easing, or quantitative easing, while giving asset prices a logical boost suggests that Qt could do the opposite.

Since 2010, QE has explained about 50% of the movement in price-to-earnings multiples in the market, 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 much did the stock market rise due to 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 are aimed at lowering yields, which is seen to boost appetite for risky assets as investors look elsewhere for higher returns. Quantitative easing creates new reserves in banks’ balance sheets. The extra cushion gives banks, which must hold reserves in line with regulations, more room to lend or finance trading activity via hedge funds and other financial market participants, thus enhancing market liquidity.

The way to think about the relationship between quantitative easing and stocks is to note that as central banks do quantitative easing, they raise expectations of future earnings. This, in turn, reduces the equity risk premium, which is the additional return that investors require for holding risky stocks on safe Treasurys, noted PGM Global’s Grape. He said investors are willing to venture further into the risk curve, which explains the surge in dividend-free “dream stocks” and other highly speculative assets amid the flood of quantitative easing as the economy and stock market recover from the pandemic in 2021.

However, with the economy recovering and inflation rising, the Fed began trimming its balance sheet in June, doubling the pace in September to its maximum rate of $95 billion per month. This will be accomplished by allowing $60 billion of Treasurys and $35 billion of mortgage-backed securities to trade on the balance sheet without reinvestment. At this pace, the balance sheet could shrink by a trillion dollars a year.

Then-Fed Chair Janet Yellen said the Fed’s balance sheet solution that began in 2017 after the economy had long recovered from the 2008-2009 crisis was supposed to be as exciting as “watching the paint dry.” It was tricky 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 economists and analysts are sounding alarm bells about the potential for a repeat of the 2019 liquidity crunch.

“If the past is repeated, then the contraction of the central bank balance sheet is unlikely to be a completely benign process and will require close monitoring of demandable liabilities on and off the balance sheet of the banking sector.” Raghuram warned Rajanthe former governor of the Reserve Bank of India and former chief economist of the International Monetary Fund, and other researchers in a paper presented at the Federal Reserve’s annual symposium in Kansas City in Jackson Hole, Wyoming, last month.

Hedge fund giant Bridgewater Associates warned in June that QT is contributing to Liquidity Gap in the bond market.

Grip said the slow pace of the cooldown so far and the composition of the balance sheet cut have mitigated the impact of QT so far, but that will change.

He noted that QT is usually described in the context of the assets side of the Fed’s balance sheet, but the liability side is what matters to financial markets. So far, the reductions in the Fed’s liabilities have been concentrated in the Treasury General Account, or TGA, which effectively serves as the government’s current account.

He explained that this actually improved market liquidity, as it meant that 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 boost the size of the TGA. Grip said the Fed will actually redeem Treasuries when the coupon maturities are insufficient to meet the monthly balance sheet cuts as part of the QT.

The Treasury will effectively pull money out of the economy and put it into the government’s current account – a net drawback – as it issues more debt. That would put more pressure on the private sector to absorb those treasuries, he said, which means less money to put into other assets.

The concern of stock market investors is that high inflation means the Fed will not have the ability to pivot on a dime as it did during past periods of market stress, Gripe said, arguing that tightening by the Fed and other key central actors Banks can prepare the stock market to test June lows in case a dip could go “well below” those levels.

The main takeaway, he said, is “don’t fight the Fed on the way up and don’t fight the Fed on the way down.”

Stocks closed higher on Friday, with the Dow Jones Industrial Average,
+ 1.19%And the
S&P 500 SPX,
+ 1.53%
and Nasdaq Compound,
+ 2.11%
After three weeks of weekly losses.

The highlight of the next week is likely to come on Tuesday, with the release of the Consumer Price Index for August, which will be analyzed for signs of declining inflation.