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Will the ramp up in Quantitative Tightening cause prices on riskier investments to go down?
The Federal Reserve’s (The Fed) use of aggressive interest rate hikes has been the focus in their fight to calm inflation. However, one of their lesser talked about tools, quantitative tightening (QT), is set to ramp up to an unprecedented level beginning in September. Because this will further tighten monetary conditions, there is concern this will have a negative effect on riskier investments.
QT is when a central bank reduces the amount of securities held on its balance sheet by (1) not reinvesting the proceeds from maturing bills and bonds, and/or (2) selling securities to meet its QT goals. The Fed began a cycle of QT on June 1st this year, but will increase the monthly roll-off cap to $95 billion per month (the highest rate ever used). As the chart below shows, conditions have been tightening since the end of 2021. Anytime the indexes climb above 0 the global economy experiences a slowdown in growth.
This brings on concern about the performance of riskier investments (like stocks) during tighter condition periods. Because, theoretically, the Fed selling Treasurys or not reinvesting proceeds into the market would put downward pressure on prices and upward pressure on rates. And, as interest yields rise and growth slows, riskier investments become less attractive to investors.
But, predictions on the effects of QT are primarily theoretical. The only other time it has happened in the U.S. was from 2017-2019, albeit at a much slower pace. In the previous QT cycle the 10-year Treasury yield actually fell. The S&P500 fell 20% in 2018, then, the Fed signaled a pivot and the S&P500 rallied before QT was paused. This insinuates that market expectations may play a more powerful role in the movement of asset prices.
As we monitor asset price trends we watch for updates in both monetary policy and market expectations. We expect tightening measures to continue as the Fed expressed it is willing to continue tightening conditions ‘higher-for-longer’ until inflation stabilizes. But at the same time, metrics like the labor market, personal expenditures, and bank balance sheets suggest the market is well positioned to handle any liquidity strains. We want to observe which side appears to be wielding greater influence on asset prices and be on the look-out for signals of change.
This material is provided for informational purposes only and is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are subject to change at any time without notice. The information and opinions contained in this material are derived from proprietary and nonproprietary sources we deemed to be reliable and are not necessarily all-inclusive. All investing involves risk, including the possible loss of principal.