Quantitative Tightening

Quantitative Tightening

8 min read

The central banking system does quantitative tightening. They sell assets they’ve accumulated to reduce the amount of money circulating in the economy. Most of these assets they accumulate and sell are bonds. In essence, they’re balancing the central bank’s inflated balance sheet.

If you’ve been following the markets over the past few years, you’ll know how much the Fed has an impact.

The Fed, or the Federal Reserve, is the central banking system in the United States.

The agency was created in 1913 and its core duties include setting interest rates, managing the money supply, and regulating the financial markets through monetary policy. When we talk about financial agencies, it is likely the most powerful one in the world. 

Despite what you might think about stocks, company performance is not always the leading indicator. Oftentimes, it is the macroeconomic environment that has a larger impact on the markets.

This environment, of course, is created by the Fed’s monetary policies. As we now know, the Fed can stimulate the economy in either a bullish or bearish way. 

One thing is fairly certain though: the Fed does not care about the performance of the equities market. That is to say, the Fed does not concern themselves with the individual price action of stocks or companies.

Rather, they are more actively involved in how monetary policies influence the broader economy. So as much as you might see investors blaming the Fed, they are not directly trying to influence stocks. 

What Is Quantitative Tightening?

The headlines recently have revolved around the Fed entering a period of QT or Quantitative Tightening. So what does Quantitative Tightening mean? It is a contractionary monetary policy that the Fed can use to decrease the total amount of liquidity in the economy.

If you remember that over the past few years, the Fed has been printing money to support the economy during the COVID-19 pandemic. Since this has led to rapidly rising inflation, the Fed is now attempting to reduce the amount of assets on its balance sheet.

Quantitative Tightening has actually been rarely used in the US economy over the years. One of the reasons? It generally leads to higher interest rates and a fairly stagnant stock market performance.

The main goal of Quantitative Tightening is to reduce the level of inflation in the economy. Unfortunately for stock investors, the policy tends to sacrifice other assets like the stock market. 

Since inflation levels in the US economy are near all-time highs right now, the Fed didn’t have much choice but to implement a Quantitative Tightening policy. Will it work? The hope is it will, otherwise the alternative might be an economic recession. 

Then What is Quantitative Easing?

On the other hand, Quantitative Easing is the exact opposite. This is more or less what we witnessed during the pandemic.

The Fed continued to print new money and provide stimulus payments to citizens.

As a result, the overall money supply in the US grew out of control.

The Fed ended up with $9 trillion on its balance sheet this year, including $4.6 trillion in treasuries and mortgage-backed securities (MBS). 

The goal of the Fed now is to reduce this balance sheet and put this money to work. Therefore, Quantitative Easing is a policy meant to stimulate the economy. This is primarily accomplished through the purchase of long-term securities.

The result of this is to increase the money supply in the economy. It has also stimulated lending and borrowing money at lower interest rates. The Fed is trying to balance economic factors like inflation by tweaking the interest rates and liquidity. 

Does Quantitative Easing Work? Anytime the economy gets a jolt, like lower interest rates, the equities markets fly higher. This is because borrowing money is cheaper, and long-term revenue multiples are expanded for growth companies.

This is exactly what we saw during the COVID-19 pandemic bull market. It is also why we see multiple contracts now that the pandemic is over. 

Will Quantitative Tightening Cause a Stock Market Crash?

It’s possible, but we’ve already seen a major correction from the major indices this year. This is because so much of the expected contractionary monetary policies might already be baked in.

Further macroeconomic factors, like issues with the global supply chain, will likely have a larger impact on the individual performance of US companies. 

At the same time, the stock market is a forward-looking mechanism. So if investors think the market will continue to show weakness, we may see a continued rotation to assets like gold or bonds.

Many economic analysts believe the impacts of Quantitative Tightening will be less severe. Why is this? The contractionary policy is usually much smaller than Quantitative Easing.

A lot of investors might believe that the impacts of QT will be the same as QE. We don’t know the exact measures being taken, but this is unlikely true.

The last time the Fed implemented Quantitative Tightening was in 2017. As usual, this followed a period of Quantitative Easing that followed the recovery from the 2008 global financial crisis.

The Fed held the Quantitative Tightening policy when the economy was strong enough in 2017 and lasted until 2019. Then we all know what happened in March 2020. 

So will Quantitative Tightening cause a stock market crash? It might. But what is more likely is a period of sideways action from the markets. Perhaps we do see a mini bear market where equities take a hit.

Given the current multiples that even profitable companies are trading at, we seem unlikely to see another crash in the stock market. 

How did Quantitative Tightening Perform Last Time?

It was a mixed bag, to be honest. Former Fed Chair Janet Yellen wanted us to believe that the policy would run ‘in the background’ of the economy.

Unfortunately, it ended up causing some market mayhem and was ditched by new and current Fed Chair Jerome Powell by March 2019. 

But this wasn’t before the global bond markets slipped three months into the policy.

It also became difficult for emerging market borrowers to secure loans as the US dollar strengthened. Finally, in December 2018, the S&P 500 index had a flash crash and fell by 16% in just over three weeks. This is when the Fed stepped in and began to move away from its Quantitative Tightening policy. 

So that is some solace for stock investors. The Fed understands that the markets are all correlated to each other. If we see a stock market crash, will the Fed step in again and ease its contraction?

That remains to be seen. The one message that the Fed has stuck with through all of this is that its main goal is to reduce inflation in the economy by any means necessary. 

The Fed Has Implemented New Policies

This is true. The Fed under Jerome Powell has implemented several changes since 2019 that could help to salvage the economy. During one of the latest FOMC meeting minutes, the Fed noted that it will be closely monitoring the markets.

This means that the Fed is definitely cognizant of past market performance under Quantitative Tightening. It also implies that the Fed will be quick to react if the markets slide out of control. 

The Standing Repo Facility is also a new policy implemented by the Fed. This allows an immediate overnight injection of liquidity of up to $500 billion if necessary.

There is a similar mechanism in place to allow the Fed to loan US dollars to international central banks as well. Will these work? That remains to be seen but at least we can say the Fed is learning from past mistakes.

Conclusion: Quantitative Tightening vs Quantitative Easing

It’s been three years since Powell ended the Quantitative Tightening policies that Janet Yellen implemented. To say Powell’s reign as the Fed Chairman has been rocky is an understatement.

What happens next is a mystery. You can read all of the predictions you want, but the fact is, nobody can predict what will happen. 

What we know is that the interest rates will continue to rise. The Fed is determined to lower inflation back to a reasonable rate by any means necessary. This doesn’t mean there will be a stock market crash, but it’s too early to bring back the rocket ship emojis.

Stock investors should expect more volatility and some near-term sideways trading until the economy is under control. However, with ongoing supply chain issues, rising geopolitical tensions, and the pandemic still impacting, it might be a while before we hear from the bulls again. 

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