US Federal Reserve’s quantitative tightening sows seeds for a market rebound
We may be in the final phase of a US Federal Reserve-inspired bear market in shares. If you want to know what happens next, listen to the Fed even more closely.
The US Federal Reserve activated a policy at the beginning of the year that can be crudely put as follows: bring down the balance sheet and boost the US dollar.
So far, the Fed has been successful on both fronts. The dollar is close to parity with the euro, at a near four-decade high against the pound and at more than a three-decade high against the yen.
Success, however, eventually leads to an end of the policy that brought it about, and sharemarket investors should be attuned to any change in course. In the short term, success by the Fed is negative for shares. And the Fed knows it.
On the other hand, when the Fed’s current balance sheet posture eventually ends it could be very good for equities.
Quantitative tightening (QT) is part of a central bank’s policy to reduce its balance sheet and liquidity. It is a reversal of quantitative easing (QE) which resulted in a cumulative $US9.8 trillion injected into markets at its peak during Covid-19, and triggered the massive rallies in equity markets around the globe from March 2020 to January 2022.
In July alone, global central bank balance sheets have shrunk by $US83bn to $US27.1 trillion. This year, it is estimated about $US2.1 trillion has been drained from money markets worldwide. And while this exercise is being undertaken, share investors have reason to be nervous. That’s because a very high correlation exists between liquidity and equity market returns.
Between January and June, the contraction of the Fed balance sheet coincided with a significant sell-off in equities. The S&P 500 fell 23.6 per cent and “profitless prosperity” stocks fell as much as 95 per cent.
During the northern summer, however, comments by Federal Reserve chairman Jerome Powell that the fed funds rate had reached a “neutral” level were interpreted as dovish (less likely to involve more rate hikes).
The comments coincided with a pause in the Fed policy to reduce its balance sheet. The rate of reduction slowed materially and, unsurprisingly, the S&P 500 rallied. Between June 16 and August 16, the S&P 500 rallied 17.4 per cent.
Then, at Jackson Hole, Powell changed course, clarifying the outlook for policy by noting inflation was the primary target and some economic pain should be expected. A sharp re-acceleration in Federal Reserve QT coincided with Powell’s comments and a surge in the US dollar. In just one week the dollar gained 2 per cent against the yen and the pound, and below parity against the euro.
Investors should therefore be attuned to changes in Fed – and global central bank – balance sheet and liquidity policy. The Fed has indicated it would like to reduce its balance sheet from $US9.5 trillion to $US6 trillion. Such a reduction, while rarely discussed in market commentary, is equivalent to a massive hike in interest rates and would thus be extremely negative for equities.
Most recently, speaking with a moderator in a virtual question-and-answer session at the Cato Institute conference in early September, Powell reinforced his earlier hawkish statements, saying the Fed would not baulk in its fight against inflation.
He noted: “We need to act now, forthrightly, strongly, as we have been doing … My colleagues and I are strongly committed to this project and will keep at it.”
Noting that history cautions against prematurely loosening policy, Powell said: “The Fed has and accepts responsibility for price stability.”
So, in the short term, there are fundamental reasons to expect another leg lower in the stockmarket. Market sell-offs, amid Fed tightening, have typically produced three legs – an initial decline, a circa 10 per cent rally, and a final third leg lower.
In the absence of alleviating economic data, interest rates will continue to rise and the Fed balance sheet will continue to contract. That suggests another leg down for equities.
Meanwhile, other Fed officials at the Cato Institute conference reportedly confirmed QE could return swiftly, if required, for financial stability. And declines in the price of oil and other essentials also increase liquidity.
It is rare to see global liquidity this tight, and eventually policy will reverse course. If the third leg of a market sell-off coincides with a slowing economy, and a Fed policy pivot subsequently transpires, the stockmarket sell-off could, next year, give way to a material rally.
Putting it all together, the success of the US central bank in its fight against inflation, and its balance sheet policy, will ultimately determine the course of the stockmarket.
Structurally higher interest rates might now be expected. But market sensitivity to balance sheet control means financial market stability (or otherwise) will be determined by balance sheet adjustments. Given the Fed is aware of its influence, equity investors can be confident a deep sell-off is an opportunity.
We may be entering a final phase of a bear market in equities. Sentiment has rarely been this glum and price-earnings ratios have compressed to the point investors who purchase shares in a company growing earnings by 15 per cent per annum over five years are unlikely to see the further 50 per cent compression in PEs required to start losing money over a five-year term.
Roger Montgomery is founder and chief investment officer at Montgomery Investment Management.
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