The Federal Reserve’s infamous post-08 policy of expanding the money supply under “Quantitative Easing” (or “QE”) is taking a 180-degree policy turn toward shrinking the same, i.e: “Quantitative Tightening” (or “QT”). Below, let’s consider Quantitative Tightening and its potential short and long-term impact on bond yields and stock prices.
On the 20th of September, the Federal Reserve officially announced its plan to commence shrinking its $4T+ balance sheet, which had grown by a staggering 5X since the 08 Crisis.
This basically means the central bank, having gone hog-wild (2008-14) buying trillions worth of GSE and UST bonds, is about to start selling its bond book, in a slow drip-like way, to the tune of $30B/month.
Is this amount of bond selling a concern?
Well, not yet. $30B a month of selling from a $4T balance sheet is kind of like removing a syringe full of water from a swimming pool: it’s unnoticeable. So on its face, the big QT announcement hardly ruffled a feather in this Turkey market.
Yet speaking of syringes…Keep in mind that the Fed’s 2008-14 balance sheet expansion (i.e. when the Fed effectively “bought the bond market” with fiat money printed out of thin air) was an obvious super-steroid for the market. In fact, this policy stimulus is unmatched in American Capitalism. We’re talking a serious securities shopping binge here…
Just consider the chart below. The correlation between rising QE (the blue color) and a rising market is hard to deny…
And now, the Fed, like a reformed Lance Armstrong, wishes to gently wean itself and the credit market off their $4T addiction to easy money. The next question is thus…
Given the massive and historically unprecedented distortions (as well as tailwinds) that QE bond buying created, it’s natural to ask: will this market bicycle continue to “live-strong” on less “dope”?
I mean, if the Fed isn’t buying billions worth of securities anymore, who will keep the “Armstrong market” moving without this steroid support?
Stated otherwise, if a fat Fed balance sheet gave us the second strongest bull market in our history, couldn’t a thinning balance sheet risk an equally historical bear slide? For it seems that after years of binge drinking from a massive balance sheet (keg party) over at the Eccles Building, our central-bank dependent markets may have a hard time riding sober…
These are big questions. Big concerns. It’s a big deal. And the market’s response?
Crickets.
In the backdrop of this largely unnoticed policy turn, the reaction from the financial media, as well (of course) from a reality-be-damned market that seems to never dip, was essentially, well: a yawn…
One would think such a reversal of the very policy responsible for our post 08 “recovery” and market bacchanalia would have markets at least a little concerned.
Not really. Somehow, the fantasy (debunked in crisis after crisis after crisis) that the central banks have super hero powers continues to keep national and global markets confident.
The symbolic announcement of American QT was met with a shrug, a brief pause, and then a continued rising market.
Of course, the TV commentators greased the wheels of this calm with their perpetual brave-speak. Like Goldie-Locks and her porridge, they tell us the Fed will adjust the balance sheet temperature “just right” to avoid any dramatic market consequences.
But is “just-right tightening” possible, or just another public fairytale that always fattens a bull and bemuses a bear?
At first blush, the QT program really does seem like a yawn. In Q4, the Fed will sell $30B of its US Treasuries and GSE holdings, which corresponds to only a $120B run rate per year of bond selling. In short, not enough to sweat this market.
But don’t be lulled into thinking the early numbers, like a gathering snowball, can’t become a market avalanche. By Q1 of 2018, for example, this selling will pick up to $240T, and by Q4, it will annualize at more than $500B, which starts to become a meaningful number.
Within 4 years, the Fed’s proposed selling plan will be approximately $2T.
That’s a meaningful number. That’s potentially an “Ouch Moment.”
Why meaningful? Because with a Fed that is “no longer buying what Uncle Sam is selling,” we will soon find that same Uncle Sam and his Treasury Bonds (like any enterprise whose supply dwarfs demand) in a real pickle.
That is, while QT is cruising along selling bonds (assuming the Fed sticks to its schedule), the US Government will be doing what it always does: borrowing and spending at warp speed—and thus offering/issuing more bonds into a market already flooded by the Fed’s increasing sale of bonds.
This intersection of: 1) continued deficit spending, and hence, 2) continued US Treasury issuance, and 3) the Fed’s QT policy of graduated bond selling (in the backdrop of an already record-high US bond bubble) potentially amounts to the first thunder-rumblings of a perfect storm.
And what would a good market storm be without a bond crisis? As I’ve written elsewhere, today’s bond bubble is the skunk in the woodpile that equity talking heads just don’t seem to grasp or give airtime—and at their peril—but hopefully not yours.
QE has driven bond yields to the floor in the US—and beneath the floorboards overseas (i.e. negative yields). That’s the power of central banks and their perma-bid, steroid effect of buying bonds and suppressing yields (see below).
Arguably then, if QE flattened yields when buying bonds, couldn’t QT spike em up when selling bonds? It’s a fair question, no?
But just how is the bond market at risk in the new QT environment?
First, let’s recall the basics of Bond-Market simplicity, namely: “Yield = Coupon/Price” (Y=C/P).
From junior-high math, we thus know that if bond Prices go down (and Coupons are fixed), this results in a spike up in Yield, and in turn, a spike up in Interest Rates.
Stated otherwise: Bond Prices have an Inverse Relationship with Interest Rates.
Given the foregoing, what could trigger a slide in bond prices and thus an inverse rise in interest rates?
Wanna guess?
How about $2T worth of bond selling? If QT actually stays its proposed course (unlikely, btw…), the Fed’s sell-off in bonds should directly affect the price downward, and thus interest rates upward.
Meanwhile, at the same time the Fed is selling (rather than buying) bonds, our US Treasury and government, like any debt addict, won’t be able to stop issuing more bonds to pay for a US budget monster that few in DC have the profile in courage to admit we can neither balance nor pay.
And so the US Treasury will keep issuing ten year “IOU’s” to pay for walls, wars, and roads we can’t afford in our new American pastime of burying our heads in the sand and kicking the debt can with both feet.
But who will buy those US Treasuries and GSE bonds if the Fed is selling rather than buying under QT?
One answer: Wall Street could step up. But in order to pay for those Treasuries, the Wall Street wunderkinder will need to sell off other securities on their books in order to raise the cash.
Maybe they’ll sell Tesla and Amazon stock or junk bonds…
You get the drift though. At some point, with the Fed no longer buying/supporting the Treasuries that keep our debt-soaked America (and bond market) running, an alternative source of buyers/money is going to have to come from somewhere.
That somewhere could be the stock market, which means a likely exit out of existing private stocks (and bonds) from our current security bubble.
In such a scenario, US bond and stock prices could fall hard as bond yields and interest rates rise.
In sum: An honest bear could argue that Uncle Sam— and thus you and I—will eventually have to pay higher interest on our historically tragic debt piles at precisely the same time that our broader securities markets are tanking without Fed “accommodation.” Again, a real perfect storm….
The bulls, however, who have faith in the Super Powers of the Fed, will be less concerned. Given that all the major central banks of the world have been using the same QE steroid plan (with combined balance sheets of now $20T+ in sovereign paper and other securities), and given that global debt in general has risen from about $50T to over $220T in the last 20 years, the bulls can argue this: “what’s a measly $2T of bond selling gonna do to scare such a massive debt bubble?”
I hear this argument a lot, and from some pretty smart credit jocks. But the logic of their confidence kinda amounts to this: “Don’t worry about heroin withdrawal—the whole world’s already hooked on it.” In other words, they’re basically saying things are soooo messed up in credit markets that it’s safe. Huh? Yep.
And who knows, maybe that kind of crazy can continue…at least until it blows apart.
In these blogs, I don’t try to time bearish arrivals or bullish exits. Macros and opinions are guidance only. Equally important are broad and narrow market signals as to asset class and cash trends, trade volume patterns, volatility moves, sector rotations, momentum reversals etc.
Here at Signals Matter, we and our Subscribers are tracking much more than opinions (bull or bear) when executing trades and managing portfolios.
But macros still matter. They really matter.
Why? Because it’s always wise to keep a skeptical eye on the macro environment when considering the level of risk to place on more micro-specific trade decisions or over-all cash allocations.
The themes addressed in these blogs provide context for asset-specific trades and risk management allocations.
As for QT and the Fed’s slow yet steady trend (quarter by quarter) to sell off portions of its bond book and thus wean the broader securities market from a liquidity-generous Fed, we hardly consider a $2T or even a $500B bond sale as “harmless.”
There are dangerous cracks in the ice of national as well as global markets, and this latest Fed move is just one more potential spot where the uninformed might eventually fall through.
And you? What’s your take on QT? Can the Fed (and markets) reap all the benefits of QE bubbles without facing any symmetrical downside? Can we, in short, get drunk on bond buying and low rates without suffering a hangover during the later bond selling and rate hiking?
For those relying on the Fed to get this right, just remember your market history: the Fed has been wrong in every bubble before this one. Its template of credit expansion leading to market implosion is an embarrassing reminder not to put your full faith in the big heads at the Fed…
As for QT and the slow and sobering process ahead, do you think the market can dodge a hangover?
Time—and our market signals—will tell.
Be safe out there.
