When the COVID-19 pandemic hit the United States in early March 2020, the Federal Reserve (FED) swiftly responded to limit the economic fallout. It adopted a range of measures, including reducing its interest rate target to near zero and implementing large-scale purchases of U.S. Treasury bonds and mortgage-backed securities (MBS). These actions, known as quantitative easing (QE), involved injecting reserves into the banking system. As a result of these purchases, the Fed’s balance sheet grew from around $4 trillion prior to the pandemic to nearly $9 trillion by the beginning of 2022.
Quantitative Easing vs Tightening
QE had first been employed by the Fed more than a decade ago as an unconventional monetary policy tool during the Great Recession. However, its return during the COVID-19 crisis suggests that it has become a more routine part of the Fed’s crisis toolkit. Nevertheless, economists continue to debate the effectiveness of QE and have limited knowledge about the reverse process of shrinking the Fed’s balance sheet, known as quantitative tightening (QT).
In response to inflation running well above its long-term target, the Fed began unwinding its accommodative monetary policy in 2022. This involved ending QE in March and commencing QT in June. When QE concluded, the Fed reinvested any maturing securities to maintain the size of its balance sheet. With QT, the Fed ceased reinvesting up to $30 billion in maturing Treasuries and $17.5 billion in maturing MBS each month, thereby passively shrinking its assets as those securities matured without being replaced. The caps on reinvestments then increased to $60 billion and $35 billion, respectively, in September 2022.
The primary goal of QE is to reduce long-term interest rates. By buying long-term assets, the Fed reduces their supply, thereby increasing their price and lowering their yield. Lower interest rates can stimulate economic activity by reducing the cost of borrowing. While some economic models suggest that QE should have little effect since it swaps one type of government liability for another, there are other theories that explain how it stimulates the economy. For instance, certain financial firms may have preferences for holding long-dated securities, and QE can also provide a signal about future Fed policy and improve liquidity conditions in financial markets.
In contrast to the debates surrounding QE, there is considerably less certainty regarding the effects of QT. The Fed’s experience with shrinking its balance sheet is limited to the previous episode from 2017 to 2019, and even then, the available empirical evidence is scarce. A recent study by economists at the Fed Board of Governors estimated that reducing the balance sheet by approximately $2.5 trillion over several years would be roughly equivalent to raising the Fed’s policy rate by half a percentage point. However, the authors emphasized the considerable uncertainty associated with this estimate.
One key difference between QE and QT lies in their signaling effects. QE typically involves a swift and somewhat surprising response by the Fed during financial crises, which helps reassure markets. In contrast, the Fed has been cautious with QT, providing ample advance notice and following a fixed schedule to avoid market surprises. The Fed’s approach to QT reflects its desire to focus market attention on the federal funds rate as the primary monetary policy instrument. While QT may not produce significant announcement effects like QE, it has been found to have stronger liquidity effects.
Shrinking the balance sheet through QT serves several purposes. It provides additional monetary tightening to bring inflation back to the Fed’s 2 percent target. Furthermore, it helps mitigate the interest rate risk faced by the Fed as it raises rates. When the Fed tightens monetary policy and increases the interest it pays on reserves, it risks paying out more on its liabilities than it earns on its assets since rates on liabilities will rise while rates on assets remain largely fixed. Shrinking the balance sheet reduces the likelihood of the Fed recording losses and enhances the credibility of its monetary policy.
Moreover, the composition of the Fed’s assets is another reason for implementing QT. The Fed holds a significant amount of MBS, but its plan for reducing the balance sheet expresses a long-term preference for holding primarily Treasuries. Policymakers and economists argue that decisions regarding the allocation of credit to different sectors of the economy should be made by Congress or the Treasury Department, rather than the Fed. However, reaching a Treasuries-only balance sheet may take time, as the pace of MBS maturing and rolling off the balance sheet depends on mortgage rates and homeowner refinancing activity.
Lastly, engaging in QT allows the Fed to free up capacity for future QE during crises. If the Fed’s balance sheet continues to expand indefinitely, it could potentially exhaust the supply of acceptable assets to purchase for QE. Therefore, by implementing QT, the Fed ensures that it has room to maneuver and employ QE as a counter-cyclical policy tool when necessary.
As the stock market undergoes a recovery from the previous bear market, there are lingering risks that could hinder its progress. One of these risks is the potential impact of higher interest rates, as well as the possibility of earnings disappointments. However, a more distinct and evident risk arises from the draining of liquidity in the global banking system from QT.
The S&P 500 (SPY) has shown a considerable increase of approximately 27% since hitting a low point in early October. This significant rally has led to growing calls for a correction, as the index has become more expensive, with a price-to-earnings ratio of 19 times aggregate forward earnings-per-share estimates compared to 15 times at the beginning of the rally. Investors are hopeful that the Federal Reserve will soon cease hiking interest rates, which would stabilize the economy and facilitate corporate profit growth. However, the impact of already elevated interest rates tends to manifest with a delay, potentially resulting in disappointing sales and earnings for companies. If the Fed maintains higher rates for an extended period rather than reducing them, these concerns could materialize. Nevertheless, positive bank earnings reported recently suggest that earnings are not currently impeding the market.
Amidst these risks, the relationship between the stock market and global liquidity emerges as a crucial factor that could impact stock performance. The global M2 money supply, encompassing cash in checking and savings accounts, as well as money-market-fund assets, has remained stagnant year over year, following a 5% decline in 2022, as reported by Morgan Stanley. Central banks have elevated interest rates by selling assets, thereby extracting cash from the banking system and reducing the amount of money available for lending and spending. Consequently, traders and portfolio managers find themselves with diminished funds.
Considering the historically close correlation between the M2 money supply and the S&P 500, Morgan Stanley suggests that the index theoretically should be situated somewhere between 3700 and 3800. This projection implies a potential 15% decline from the current levels.
Although such a sharp drop may seem improbable given the market’s awareness of the liquidity drain caused by central banks, it is important to acknowledge the reasoning behind Morgan Stanley’s analysis. Despite expectations of lower liquidity levels, the mechanics of having less money within the system could have an adverse effect on stock demand. Portfolio managers have already reduced their cash holdings as they capitalized on buying stocks over the past several months. Additionally, consumers may eventually curtail their spending as they exhaust their cash reserves, even if this impact has yet to be reflected in second-quarter earnings reports. The Fed’s commitment to stepping in at the first sign of crisis, though, has given the market the confidence needed to adopt a risk-on approach with the purchase of stocks, especially in the growth sector. While logic may lead you to believe that a bank of Silicon Valley’s scale collapsing would be a huge red flag for the economy, the Fed’s immediate quantitative easing in response has helped fuel this rally. The balance sheet has already moved below pre-March levels but that quick spike in response to SVB’s demise has investors confident that the Fed will step in to save the day. But with liquidity falling, there may not be enough fuel to continue higher.
With SPY hitting a yearly high and VIX hitting a low, it may be prudent to prepare for the upcoming uncertainties surrounding continued QT with the FED balance dropping below pre-SVB collapse levels again. While I think the soft landing is achievable and am not calling for a market collapse, the recent run-up has made downside protection cheap and having hedges in place (especially with a strong risk-reward ratio) can be part of a healthy securities portfolio.
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While the stock market has made significant strides in its recovery from the bear market, it remains vulnerable with the draining of liquidity within the global banking system, coupled with potential earnings disappointments, are risks that could influence the market’s trajectory and performance. The general belief is that QE has a positive effect on the economy, there is less certainty regarding the impact of QT due to limited empirical evidence. The Fed is cautiously implementing QT to achieve additional monetary tightening, reduce losses and interest rate risk, allocate credit decisions appropriately, and preserve capacity for future QE. The uncertainties surrounding QT necessitate ongoing research and evaluation of its effects on the economy.