What the Fed’s ‘quantitative tightening’ mission could mean for markets
The worst year for stocks since 2008 could turn uglier, as the Fed’s efforts to withdraw potentially trillions of dollars from financial markets hit with full force.
News leadership: The Fed has opened a second front in its fight against inflation in recent months, moving to shrink its stockpile of US government bonds by nearly $9 trillion — a process known as quantitative tightening.
- In September, it raised the rate of reducing its holdings to nearly $100 billion a month.
- The Fed also continues to raise short-term interest rates, posting its third consecutive rise of 0.75 percentage points on Wednesday.
why does it matter: The Fed’s only previous attempt to raise interest rates and simultaneously reduce its holdings of government bonds coincided with an ugly 20% sell-off in the stock market in late 2018.
- The S&P 500 is already down 21% from its peak early this year, after the Federal Reserve launched its efforts to crush inflation by raising short-term interest rates.
- The big question: With quantitative escalation just now, is the other shoe on the cusp of a downturn in the market?
what are they saying: “Lack of bond market support and downturns in the financial system are creating another set of headwinds for the economy and financial markets,” wrote John Lynch, chief investment officer at Comerica Wealth Management.
The Big Picture: When the economy entered a COVID-related downturn in early 2020, the Fed began pumping newly created dollars into financial markets as part of its efforts to ensure the economy did not turn into a smoldering crater.
- It did so by buying more than $4 trillion worth of government-backed Treasuries and mortgage bonds.
- Buying these bonds lowers long-term interest rates, which in turn lowers mortgage and auto loan rates, convincing Americans to spend their money rather than hang on to it in scary times.
- The plan largely succeeded, and car and home sales rose during the crisis. (Some also blame it for fueling current inflation issues.)
Between the lines: A side effect of the plan was the record growth of the stock market, as newly created money flowed through the system.
- The stock market rose 114% between March 2020, when the Fed announced its quantitative easing program, and peaked in January 2022.
- Some analysts believe that the effect of the Fed’s money-printing and bond-buying programs may have affected the crazy mood of the markets – MIM stocks! Spax! Encryption! NFTs! Over the past two years, every slight drop in stocks has been met with traders rushing to “buy the dip.”
Bottom line: Now that the Fed has shrunk its balance sheet — effectively withdrawing $100 billion from financial markets each month — some expect the tailwinds of the massive pandemic era to turn into massive headwinds for an already turbulent stock market.
- “The idea of buying dips became firmly entrenched with investors during the post-COVID leap from mid-2020 through 2021. Many considered it an almost foolproof strategy,” Steve Sosnick, chief strategist at Interactive Brokers in Greenwich, Connecticut, wrote in a recent note to clients.
- “What made it work was the influx of money released by a combination of interest rate cuts, quantitative easing, and fiscal stimulus.”