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Will Quantitative Tightening Wreck the Markets?
Recently, there has been a flurry of posts and opinions claiming that the application of quantitative tightening (QT) is draining liquidity at a rate that is clamping down on investments in securities and provoking the recent stock market correction. This Federal Reserve policy and its possible effects are the topics of this piece.
Before I dive into this controversial topic, I should point out that I am long equities, and have changed my investing strategy over the past year or so. I did not own individual stocks until a few years ago. I began to sell and buy individual securities; while some of the selling had rhyme and reason, I fell into a trading pattern without realizing it. This cost me in anxiety, commissions and mixed investing results.
I realized that I needed to sharpen my strategy, that there was too much risk in my portfolio and that I needed to reduce the trading. I used the first part of this latest, second correction of 2018 to replace or reduce some high-yielding stocks with more middle-of-the-road securities. I have replaced an excess of trading and market timing moves with a buy-and-hold approach generally.
Like most investors, I am troubled by the depth of this latest correction. But I have not panicked, and in fact have not reduced the percentage of stocks in my portfolio (it also includes two bonds).
What is Quantitative Easing?
Quantitative easing (QE) is an expansionary monetary policy conducted by central banks for the purpose of stimulating the economy and increasing available liquidity. The banks accomplish QE by buying preset quantities of government bonds and additional assets. Quantitative easing is sometimes used in periods of low inflation and when standard means of expansionary money policy have proven ineffective.
Source: CNBC | Giorgio Tonella. Figure 1: A Representation of QE
Quantitative easing is implemented when those banks purchase assets from commercial banks and other institutions. These purchases raise the price of those assets while lowering their yield. They also cause a reduction in short-term interest rates – increasing the money supply. (This is not the same as the central bank buying short-term government bonds to control interbank interest rates.) More information on QE is available here and here.
In fact, the failure of short-term bond purchases to lower rates may provoke the central banks to try QE as an alternative to stimulate the money supply. Buying assets without referencing the attached interest rates and purchasing risky or longer maturity assets will lower interest rates further out on the yield curve.
While quantitative easing can help ensure that inflation does not fall below a defined threshold, it may at times provoke unwanted inflation. QE may also be ineffective should commercial banks remain reluctant to lend and borrowers to borrow. Most views of the US Federal Reserve’s easing since the global financial crisis of 2007-08 conclude that this application of this specific monetary policy has been somewhat effective.
This massive effort was the first of its kind and is believed to have helped stir the stock market to new heights in the ten years since the crisis. Many observers now make a direct connection between the central banks regularly buying assets and across-the-board increases in stock prices. Concurrently, the success of QE may have helped plant the seed for the use of quantitative tightening (QT) to reverse its effects.
What is Quantitative Tightening?
Quantitative tightening (QT), the opposite of QE, is a policy intended to contract the money supply and reduce the liquidity within an economy. The primary purpose of QT is to raise interest rates so as to reduce demands for goods and services and to prevent inflation. Another side purpose may be to cool off the hot stock markets and prevent a stock market bubble that might be precedent to a harmful crash.
As with its opposite, QE, quantitative tightening on a mass scale is a new central bank endeavor. This makes it an untried experiment with impact and consequences yet to be explored.
Its premises are sound, assuming the Federal Reserve is right that the environment has become inflationary and that cooling off corporate and personal spending is an appropriate policy. That is, the tightening will likely have at least some of the effects desired.
Whether it is necessary to slow down the rise in markets, whether a bubble was on the creation, and whether the reduced liquidity might lead to a bear market and a recession are open questions whose answers also belong to the universe of quantitative tightening’s effects.
Economic and Market Factors in Relation to QT
A number of factors are present in the economy and markets at any time – and also during quantitative tightening.
Economic growth rates are a measure of the performance of the overall economy. They may also speak to corporate health and profit levels and may relate to the fortunes of individual companies. That is, economic growth is to a considerable extent the sum of corporate performance lubricated by government expenditures (these are funded by taxpayers or in some cases not funded at all).
If economic growth is strong, then both the economy and the markets can tolerate a reduction in liquidity. A strong economy might overheat – a motive for measures to quiet inflationary pressures. Quantitative tightening is one primary instrument for achieving that.
According to the Trading Economics:
The US economy advanced an annualized 3.4 percent on quarter in the third quarter of 2018, slightly below earlier estimates of a 3.5 percent growth, final figures showed. It follows a 4.2 percent expansion in the previous period which was the highest since the third quarter of 2014.
This matches figures from the U.S. Bureau of Economic Analysis.
It looks very much as if the Federal Reserve sees signs of continuing overheating, a view consistent with the latest rate hike, the guidance for 2019 and the reliance on QT as a strategic tool.
The risk is that Powell’s evaluation of both the strength of the economy and the risks of inflation are exaggerated or wrong; if so, then QT will contribute to squeezing economic growth and make it harder for companies to sell goods and make profits. The practical result is to build in "silent" rate hikes by rolling assets off the government books. The effects on stock prices will likely be negative as a result.
Inflation is a specific factor in the evaluation that seems to have an "overweight" effect on the Fed’s decision. There seems to be an emotional component to fears of inflation – based perhaps on periods in which it has damaged overall economic prospects. This may have caused Jerome Powell and the Fed to overreact to mild inflation and exaggerate the threat in implementing QT.
Source: Trading Economics, BLS. Figure 2: Inflation Through 2018
The impact of tariffs on the American and international economy (and the two are interwoven) is part of the economic forecast. Whether the Federal Reserve calculates the impact of tariffs is not clear; in any case, it is a very difficult to attempt to do so given the uncertainties around the level of tariffs. Even if the levels were somehow known, their effects on the economy are uncertain. Economic history reveals that tariffs and protectionism harm economies over time, so if the Fed relates to this issue it should argue against quantitative tightening.
Federal Reserve Rate Hikes and QT
In hiking the interest rate another 0.25 basis points last week and estimating that it would raise twice in 2019, The Federal Reserve under Mr. Powell made a statement that the markets heard as resoundingly negative. Given that this Fed meeting occurred during a sharp correction – the second of the year – the decision accelerated the "sell" momentum. The selling since the Dec. 19 announcement has accelerated to the point that the U.S. markets teeter right on the edge of a dreaded bear.
The markets had "hoped" for just one rate hike next year, and the fact that Powell spoke of unknowns that might influence the decision regarding 2019 did not calm the markets. The doves were disappointed, and the chairman’s polite taskmaster tone did not help matters.
Then there was Powell’s statement at the Fed’s press conference about quantitative tightening itself:
We came to the decision that we would have the balance sheet run-off on automatic pilot and use rate policy as the active tool of monetary policy. I don’t see us changing that.
This no doubt was the kicker that set equivocating traders to sell. It was a perfect trifecta: one more rate hike for 2018, and two promised tentatively for 2019 against the hopes of the markets and a rigorous defense of quantitative tightening. Rate hikes might be reduced if the data indicated, Powell clearly implied.
QT is “the active tool of monetary policy” – and set in stone. An unchangeable fact of monetary policy. The markets reacted as they should if we factor in the known investor psychological drivers: fear and greed.
While withdrawals from stocks and mutual funds have accelerated and are occurring at a much higher rate than the Fed’s monthly asset sale, it looks clear that the results of this past week’s Fed meeting provoked mass selling. A triple dour message of another hike, two more raises next year and a reiteration of QT as a permanent facet of monetary policy is helping drive stock prices down. Of course, there are additional factors including year-end selling, hedge funds apparently closing, the ongoing trade skirmish with China, likely recession in Europe and in China, and US political instability featuring evolving chaos around the Trump administration, its relations with Congress and the Mueller investigation.
There is enough bad news out there, and there is the precedent of an early-year correction. It is my guess that few people predicted a second 2018 correction, and now that it is here the psychological effects on investors are exacerbated.
True understanding of the effects of the quantitative tightening will take time. History is not written in the present. It appears that QT, married with continued rate hikes and the macro factors mentioned, present a major challenge for the markets. You can tell investors all about valuations and forward PE ratios, but in the end emotions rule many involved in the markets.
QT is at the heart of an austere monetary policy, and in the larger sea of uncertainty, it creates a negative dynamic for the markets in the short and perhaps medium term.
In the longer run, investors should not interpret current Fed monetary policy as institutionalizing a permanent bear market. Because of the correction, valuations of many individual stocks have come down to quite reasonable levels. The U.S. economy is not in recession and displays no signs of entering one; nor do likely recessions in Europe or Asia necessarily "infect" the powerhouse American economy.
It may well be that the current correction is becoming a bear market. If so, then quantitative tightening will have played its role. However, the pressure on the Fed from the administration and the markets, and Jerome Powell’s statements implying flexibility regarding future interest rate hikes, may at least stop the interest rate hikes.
In the meantime, the market is in distress and the pain may linger. If this situation eventually leads to a relaxation or reduction in the intensity of QT itself, that would be a likely trigger to a market rebound and a resumption of the long-term bull.
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.