Great unknown: Markets brace for turmoil as the Fed unwinds its 14-year experiment

While the focus of financial markets and economists last week was on the US Federal Reserve Board’s big hike to US interest rates, something else of equal - if not greater - significance for markets and economies also occurred last week.

The Fed started its process of “quantitative tightening”, or QT, last week. That involves allowing the massive hoard of bonds and mortgages that the US central bank has accumulated through its waves of quantitative easing (QE) – its purchases of bonds and mortgages – to run off by not reinvesting the proceeds from maturing securities.

Global sharemarkets are coming under increasing pressure. Credit: AP

Last week $US15 billion ($21.6 billion) of Treasury securities held by the Fed matured without the proceeds being reinvested. By the end of the month $US47.5 billion of Treasury and mortgage-backed securities will be allowed to mature without reinvestment. The same will occur in July and August before the amounts double to $US95 billion a month from September.

Just as QE – first rolled out in response to the 2008 financial crisis and then doubled down on in response to the pandemic – was unprecedented, so is QT.

Since 2008 then has only been one attempt to shrink a Fed balance sheet that swelled from less than $US1 trillion before the 2008 crisis to about $US4.5 trillion ahead of the pandemic and now stands at about $US9 trillion.

That was in late 2018, when the Fed tried to nudge US interest rates up and allow maturing securities in its portfolio to run off. Markets convulsed amid signs of a liquidity crisis and the tantrums in equity and bond markets – and from the Trump White House – caused the Fed to reverse course.

While the 75-basis-point increase in the federal funds rate last week increased the price of credit, QT impacts its availability. In effect the Fed has started withdrawing credit from the US financial system and, because of the primacy of that system, the global financial system.

Reducing its purchases of Treasury and mortgage securities will progressively remove the Fed from the demand side of those markets, with obvious implications for those markets given that it was buying $US120 billion of those assets each month until it halted the purchases in March.

It also has implications for the amounts of liquidity that have been sloshing around the US financial and global systems; implications that will be magnified if and when the European Central Bank and other central banks also follow through on their commitments to start their own QT programs.

On some estimates, more than $US4 trillion of central bank buying could be withdrawn from the markets over the next 18 months.

The combination of the Fed’s rate hikes – it has foreshadowed another 75-basis-point increase next month, and the likelihood that a federal funds rate that was near zero at the start of this year could be 3.4 per cent at its end – and the start of QT means the price of credit will be rising even as its availability is falling.

Market volatility has spread to cryptocurrencies, which have been tumbling. Credit: Getty

If the Fed doesn’t blink in the face of the steep selloffs in equity and bond markets, QT is as big a step into the unknown as QE was.

QE produced some unintended, or at least incidental, consequences. Not the least of them was a steady and ultimately near-complete erosion of any pricing for risk, which drove financial markets to extreme levels; levels that could only be justified by the absence of alternatives that could produce positive results and by a conviction that the Fed and its peers were providing a rising floor under all financial assets.

The outbreaks of inflation at 40-year highs in this post-pandemic environment of supply chain disruptions, labour shortages, continual COVID outbreaks in China and energy and food market shocks flowing from Russia’s invasion of Ukraine have pulled those rugs from under the markets.

The Fed can’t ignore an inflation rate of 8.6 per cent, just as the European Central Bank can’t ignore its rate of 8 per cent and rising or the Reserve Bank our rate of 5.1 per cent and rising. They are going to do whatever it takes to stamp out inflation, even if that results in another of those recessions we have to have, like the one Australia experienced in the early 1990s.

It has been the transformation of the Fed from dove to hawk, almost overnight, that has burst the bubbles it was largely responsible for creating in equity and debt markets. It’s also blown up the most speculative and risky asset class of them all, the market for crypto assets.

While the US sharemarket is down about 23 per cent since the start of the year and the tech-laden Nasdaq market is about 33 per cent off its peak late last year, the market capitalisation of crypto assets has plunged from $US3 trillion last October to about $US880 billion today.

The crypto flagship, Bitcoin, traded at a record level of just under $US70,000 last year and had a market cap of about $US1.2 trillion. Over the weekend it was trading as low as $US17,599 and, while it bounced back just above $US20,000, the whole market for Bitcoin is now valued at about $US390 billion. Bitcoin is proving to be the leading indicator of risk appetites in the market.

Just as QE – first rolled out in response to the 2008 financial crisis and then doubled down on in response to the pandemic – was unprecedented, so is QT.

While the realisation that rates were going to march steadily higher this year - and keep rising until inflation is brought under control - explains why markets have tanked, there are already signs of reduced liquidity and a lack of depth in markets that is contributing to the size of falls.

In this opening phase of QT, that would almost certainly be more attributable to risk aversion by investors and lenders (there are reports of significant levels of margin lending and subsequent calls in the crypto market) than to the Fed’s balance sheet strategies.

It’s a sea change in attitudes to risk that is having the biggest impact on markets.

In the bond market, a fear of the value of bonds and the income they generate being overwhelmed by inflation has seen yields soar. At the start of the year, US 10-year bonds were yielding 1.5 per cent and two-year notes 0.73 per cent. They now yield 3.23 per cent and 3.2 per cent respectively.

In the junk bond market – the market for bonds issued by companies with poor credit ratings – the spread between the yields on the bonds and US Treasuries started the year at about 2.8 percentage points. Today it exceeds five percentage points.

Around the world rates are rising and credit conditions are tightening and - unless something unforeseeable occurs - rates will probably keep rising until at least well into next year and central bank liquidity will continue to be withdrawn for several more years.

For the over-leveraged governments, businesses and households that have been encouraged for nearly a decade and a half to gorge on cheap credit, that’s an intimidating prospect.

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