- The Fed has ratcheted up interest rates this year, but that's only half of its approach to fighting inflation and taming frothy markets.
- Quantitative tightening is meant to suck excess liquidity from the market, fighting inflation and deflating bubbles.
Inflation has weighed on markets all year, with the Fed hiking rates by over 300bp in a scramble to rein in sky-high prices.
The aggressive and historic rate hikes are just half of its approach though, and there's another tool the central bank has been employing more recently to help crush inflation and deflate market bubbles that formed as a result of years of easy monetary policy.
Unfortunately for investors, that tool is also set to weigh on stock and bond markets, maybe even more so than the Fed's rate hikes. Such a massive change in liquidity conditions has sparked fears that quantitative tightening—the runoff of the Fed's $9 trillion balance sheet—could end in a market crash.
Here's how two experts explain the Fed's QT regime, and why it's a delicate balancing act between fighting inflation and keeping markets afloat.
What is quantitative tightening and what does it mean to reduce liquidity?
When the Fed undertakes quantitative tightening, it's reducing the size of its balance sheet. Those are the assets the central bank has accumulated, such as long-term government bonds, which eventually mature and allow the Fed the get back the principal on those bonds. Once they mature, the Fed can either reinvest that money, or it can reduce the size of its balance sheet by simply letting the bonds "run off." During quantitative tightening, the Fed chooses not to reinvest.
This is slightly different than if the Fed were to actually sell the bonds on its balance sheet into the market, but it has a similar effect of pushing rates higher.
The Fed is shaving off around $95 billion of Treasury bonds and mortgage securities from its balance sheet a month. Essentially, that's lowering the demand for long-term bonds, causing real long-term interest rates to increase.
What is the effect of QT?
The Fed hopes it can help reduce inflation. When real-long term interest rates increase, that lowers asset prices, bringing a slowdown to inflation. Higher rates also encourage households to save more, discouraging the kind of consumption or investment that overheats the economy and stimulates inflation.
Does it impact stocks?
Similar to higher interest rates, which can eat into corporate profitability and depress stock prices, QT can have an adverse effect on equities.
Remember, QT drains liquidity from markets by removing a guaranteed buyer of massive amounts of debt securities. Removing that much liquidity from the market inevitably has a cascading effect, and bubbles like the meme-stock craze that took hold of markets during the pandemic will wane.
According to Amir Kermani, an economist at UC Berkley, this is also because when long-term interest rates for bonds increase, investors will want to shift from stocks to long-term bonds.
So, no more meme stock craziness?
Taken together, quantitative tightening and interest rate hikes will likely 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.
"That would be way too simplistic to just boil it down to that," Contopoulos said. He pointed out that a lot of the pandemic-era stimulus money has worked its way out of savings, which was a major driver for interest in stocks. The Fed's rates hikes have also reduced the appetite for stocks this year by increasing short-term interest rates.
With three-month government-guaranteed Treasuries yielding upwards of 4%, why risk money in the stock market that's down 20% year-to-date?
When will QT end?
The quantitative tightening regime can't last forever, Kermani says, and it's likely that the Fed will need to start slowing the pace of its balance sheet reduction. That's largely because money coming off the balance sheet has mostly been coming from the excess reserves, which are used by banks to meet liquidity needs.
Kermani estimates that the financial system may not be able to tolerate banks' excess reserves dipping below $2 trillion, which could lead the Fed to stop QT sometime late 2023. He added though that the Fed would likely wait for clearer signs of inflation rolling over before slowing the pace of quantitative tightening.
Do stocks rally after QT ends?
There's hope for a 2023 bull run, according to Bank of America, which says even a shift from quantitative tightening to "tinkering" would stimulate stocks.
Though, other experts have their doubts as to the tailwinds provided by an end to QT.
"Quantitative tinkering will have a temporary effect," Contopoulos said. "Our research shows the profit recession is just about to start and will pick up steam into 2023."
He noted that stocks were largely influenced by the Fed "popping the liquidity bubble" in the first six to nine months of this year, but Fed policy will have a smaller impact on stocks later as markets shift focus to corporate earnings.
"I think the next leg of the race lower in stock prices is going to be driven more by the lack of earnings growth than it is going to be by anything the Fed does."
Is it possible the Fed's messes this up?
Kermani says quantitative tightening won't 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 halt the quantitative tightening process altogether at this point.
"That's a huge mistake for the Federal Reserve to change their mind because of being afraid of what's going to happen to stock prices. We don't want to live in a world where the Fed is in charge of insuring the stock market. So I think some gradual adjustment of market prices is actually not bad," he said.