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FOMC's Quantitative Tightening: Best And Worst Case Scenarios

by: Al Moghadam

I outline the best-case scenario as the Fed reduces its balance sheet.

We require 7 to 10 years of robust growth for the balance sheet reduction to go smoothly.

The worst-case scenario could lead to a recession and even stagflation.

Without new legislations on tax reform and government spending, I believe it is more likely to end up closer to the worst-case scenario.

On Sept. 20, 2017, the Fed expressed its intention to start the QT (Quantitative tightening) process by allowing $10 billion of the bonds it holds to mature and not reinvest. The Fed currently holds $4,500 billion its balance sheet. $10 billion is a drop in that bucket. The Fed as promised is being extra careful with QT. Most likely, taking $10 billion liquidity out of the market every month will not be noticeable. The pace is said to be picked up eventually to $50 billion per month if the conditions are right. There is no clear indication on when the balance sheet will return to "normal", however some back-of-the-envelope calculations indicate 5 to 10 years. Recently, an article on Seeking Alpha (here) also showed 2025 as the year the balance sheet could return to its neutral value assuming everything goes according to plan. It is difficult to know how the monetary policy and with it the economy will move forward. Similar to when QE was announced and most experts expected high inflation to follow, QT can surprise as well. In this article, I will look at two extreme scenarios that can materialize. Looking at the extremes can help setting bounds on what to expect in the future and how to prepare for it.

Best-Case Scenario: What the Fed Dreams of Happening

In the best-case scenario, as the Fed reduces its balance sheet, the Treasury yields increase both long and short term. The increase in yields paves the path for interest rate hikes. This will take some liquidity out of the markets (stock market) as increasing Tbill yields will cause some investments to move from risk assets to Treasuries. In the ideal scenario, as the Fed removes some of the excess liquidity, the economy picks up steam and GDP grows at over 3%. The inflation under these conditions should pick up as well. In that case the corporate earnings grow materially (with GDP growth) and therefore a huge sell-off in the stock market is avoided. This supports a healthy yield for the Treasuries, higher interest rates (2.75% to 3.5%) and a healthy stock market. The stability never stays long in the market. It eventually overheats (inflation) and monetary policy (increasing rates) will lead to another recession (ideally mild). At that juncture, the Fed can cut rates and inject cash again into the markets to ease the pain of the recession.

The above scenario is what the Fed dreams of happening. But how likely is this scenario at the moment? It was certainly easy to believe this as a viable scenario in 2009 when it started the QE experiment. There are a few big assumptions in the best-case scenario. The biggest assumption is that the economy grows at a healthy rate for the duration of the quantitative tightening process. From what I mentioned before, it should roughly be until 2025. While 7 to 10 years of robust growth is reasonable to expect during a post-recession recovery, it is unlikely for it to occur at the later stages of the recovery closer to the peak of the business cycle. The question then becomes are we still in the early recovery stage of this business cycle? Is there another 7 to 10 years left before the next recession?

To answer this question, the financial data are mixed. Depending on what data you look at, you might have a different conclusion. However, most of the data indicate we are closer to the end of this cycle.

For example, the unemployment level shown above is sitting at 4.4% indicating a very tight labor market by historical standards. Historically, the GDP has never grown significantly under such tight labor conditions (GDP also shown on the plot). The money injected in the form of QE does not seem to have been invested in the economy to create high paying jobs. There is no inflation and wage growth to encourage consumers to spend more and propel the economy.

If part time and low paying jobs (underemployment) are a significant contributor to tight employment, then perhaps there is a bit more room in the labor market for growth. However, the new monetary policies of raising rates and reversing QE will dampen economic growth and growth of full-time employment.

Looking at a combination of leading indicators above (leading index), it seems that we are potentially close to the end of the post-recession recovery rather than the beginning. During every recovery, the leading indicator has peaked at 2%. In the present recovery, leading index reached 2% between 2012 and 2014 and is decelerating now sitting at 1.22% in July 2017. The leading index is theoretically ahead of the economy, therefore currently it is pointing to a slowing economy in near future.

Finally, the yield curve seems to be inverting which signals that market participants are losing faith in the economy in the short term. There are several other indicators that point to the fact that we are potentially close (1 to 3 years) to the end of this recovery (car sales, margin debt, consumer debt, etc.). Besides the current economic indicators, the path of raising interest rates could only increase the chances of a recession occurring.

Looking at the present data, it seems unlikely that a recession is avoided for another 7 to 10 years until the Fed has removed the excess liquidity from the markets. In my opinion, the only way to spur real growth at this point in the cycle is a tax “reform” rather than cuts. Tax cuts should ideally be directed at corporations, middle, and lower class rather than the wealthy. It is very unlikely at this point that a tax break to wealthy individuals will lead to growth. Since it won’t lead to consumption which is 70% of the US economy. If the majority of the US population have no money (and no wage growth), there is no point for any company to expand production.

Tax cuts to the wealthy at this junction will only lead to a bigger stock market bubble. Especially considering the soaring federal debt, the tax breaks also need to be at least almost revenue neutral. I believe this is the reason for the recent plans by the Canadian government to crack down on the tax loop holes used by wealthy individuals in healthcare and law to pay some of the lowest taxes in the country. Although their execution certainly needs some fine tuning. In case of a meaningful tax reform, I believe exposure to stocks can provide good returns. Otherwise, I recommend hedging some of your portfolio with risk-off assets, precious metals, and companies with safe revenues.

The Worst-Case Scenario

In the worst-case scenario, a recession will happen within one to three years of the start of QT. The market will still be awash in liquidity and the yields will drop significantly as the stocks and other risk assets fall. Meanwhile the Fed will have to drop the rates to zero or negative. The excessive liquidity can result in stagflation (black swan event leading to a rise in price of oil will certainly do it). Bonds and precious metals should benefit from this.


The best-case scenario requires 7 to 10 years of robust economic growth. This does not seem to be a realistic case unless fundamental changes are made to government revenue (taxes) and spending. The story will likely unfold somewhere between the worst- and the best-case scenarios that we discussed here. If things move forward with the current momentum, I believe a recession is coming sooner than seven years and the excessive liquidity will cause real harm. I don’t see the Fed having any other choice but to try to remove the liquidity as soon as possible; however, without new legislation, it will likely expedite the move towards a recession. Therefore, under the current tax regime, I recommend dedicating a portion of your portfolio to risk-off assets, precious metals, or companies with safe revenues.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.