Could the Federal Reserve’s quantitative tightening turnaround spell trouble for stocks?
Recent comments from outgoing US Federal Reserve Chairman Jerome Powell have sparked debate. Speaking at the National Association for Business Economics conference on October 14, Powell hinted that the Federal Reserve’s (the Fed’s) long-term quantitative tightening (QT) program – the methodical deleveraging of the balance sheet bloated by pandemic-era stimulus – may be “in sight” of an end.
While it may come as a relief to many stock investors, the QT halt may not be the good news stock investors are hoping for.
Background
QT, launched in June 2022, has caused the Fed to roll off up to $95 billion in bonds and mortgage-backed securities every month without reinvestment. In other words, as the bonds the Fed previously purchased and held under Quantitative Easing (QE) mature, they will not be replaced by additional purchases. QE becomes QT.
The QT process withdraws liquidity from the system (the balance drains), effectively tightening financial conditions in combination with interest rate increases. Since peaking at nearly $9 trillion, the Fed’s balance sheet has shrunk to about $6.6 trillion, draining reserves from banks and forcing private market participants to absorb a larger share of the government’s current debt issuance.
For stocks, QT should be a drag. Reducing the amount of bonds the Fed has on its balance sheet reduces the amount of cash injected into the financial markets through QE-related bond purchases thus far, thereby reducing the amount of “easy money.” It also raises interest rates on government bonds and other safe assets, making borrowing more expensive for both companies and consumers. The resulting higher interest rates traditionally lure investors from riskier stocks to bonds, curbing the risk-on sentiment that fuels bull runs.
The problem is that stocks have soared to record highs, reflecting the fact that the Fed has not dealt with QT at all. Thanks to ‘underhanded’ liquidity injections through reverse repos and other instruments, quantitative easing has essentially continued uninterrupted. The Fed has not taken liquidity out of the system.
With the “secret packages” reportedly exhausted, the Fed faces a crossroads. Ending the QT could risk further depleting bank reserves if Treasury issuance floods the system with short-term notes – a maneuver some are calling “Treasury QE.”
The signal that matters
Powell’s speech was superficially “forgiving.” He reiterated the Fed’s plan to end the QT once bank reserves fall “slightly above” levels considered “sufficient.” He indicated that this point could be reached in the coming months, and that the central bank is closely monitoring the indicators to guide the decision to end the balance sheet reduction.
But hidden within the optimism was a warning: don’t expect the broad market wave of traditional quantitative easing (QE); It will be targeted liquidity channeled into ‘real economy’ priorities such as defense spending, artificial intelligence capital expenditure (AI capex) and the purchase of strategic raw materials.
The financial markets may not receive this news optimistically.
As Michael Howell noted, this “difference in skin color” could be a “worry” for stocks as budget targets take priority over broad liquidity support. US banks, already nervous about recent problems in the regional sector (Zions Bancorp fell 13 percent due to loan write-downs), could hoard reserves, which would shrink corporate lending. Less credit availability means tighter margins for indebted companies, dealing a direct blow to the earnings multiples that have supported the S&P 500’s price-to-earnings ratio of 20+.
How ending QT could backfire on stocks
The end of QT is a double-edged sword that could be bearish for stocks. First, the QT termination signals the Fed’s tolerance for a larger balance sheet, which could potentially increase inflationary pressures again. JP Morgan has warned that if fiscal spending (for example, defense purchases) accelerates through government bonds, yields could rise further up the curve as markets price in higher deficits. The sentiment that lasted longer and longer was what crushed the stock in 2022; A similar dynamic could once again drain capital from technology indices today. If the Fed ends the QT program, liquidity targeted at government priorities could bypass stocks, starving stock markets.
Powell also emphasized avoiding a 2019-style “money market strain,” where repo rates spiked due to reserve shortages. Ending the QT now, with reserves at 10-11 percent of gross domestic product (GDP) (nearly “broad” thresholds according to Fed Governor Waller), may seem sensible. But a shift to issuing heavy government bonds (T-bills) could worsen volatility if banks deplete reserves faster than expected. Meanwhile, the surge in gold could be a signal that something in the system is about to break.
For equities, lower liquidity has always led to sharper sell-offs due to bad news.
Ending the QT could flood short-term markets while raising long-term rates, stabilizing the curve, but at the expense of stock market multiples.
A fork in the road?
Powell’s pivot isn’t a complete revival of QE either. Well, not yet anyway. The reported tensions in the repo markets call for vigilance, especially as the rosy interpretation of Powell’s comments — “more liquidity equals higher equities” — ignores the nuance that the Fed’s change of course prioritizes systemic stability over stock euphoria.
If ‘Treasury QE’ redirects cash in a way that favors real recipients, such as defense, bypassing stock markets, we could see more losers than winners.
Roger Montgomery is the founder and chairman of Montgomery Investment Management. Roger has more than three decades of experience in fund management and related activities, including equity analysis, equity and derivatives strategy, trading and securities brokerage. Before founding Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also the author of the best-selling investing guide to the stock market, Value.able – how to value and buy the best stocks for less than they are worth.
Roger regularly appears on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
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