The Federal Reserve’s unprecedented quantitative-tightening campaign is finally ramping to its full-steam speed in Q4. That will destroy $50b per month of quantitative-easing money created out of thin air! QT will need to maintain this terminal pace for over two years to meaningfully unwind the Fed’s grotesquely-bloated balance sheet. This record tightening poses a dire threat to today’s QE-inflated overvalued stock markets.
This week traders are focused on the Fed’s 8th rate hike of this cycle, which was universally expected. Ever since the FOMC’s previous meeting in early August, federal-funds futures have implied odds of another hike way up at 91% to 100% at this latest meeting. But the Fed’s ongoing hiking pales in comparison with what it’s doing with its balance sheet. One year after its birth, quantitative tightening is hitting full speed.
Rightfully concerned about QT’s impact on the lofty stock markets, the Fed prudently took an entire year to ramp it up to terminal velocity. QT started almost imperceptibly at $10b per month in Q4’17, before being ratcheted up another $10b monthly in each subsequent calendar quarter. The final increase is going into effect in this imminent Q4’18, taking QT to a staggering $50b-per-month pace. That’s record tightening!
QT is incredibly bearish for today’s record-high, bubble-valued stock markets late in a record bull that was largely driven by the Fed’s earlier extreme quantitative easing. QE conjured literally trillions of dollars out of thin air to keep interest rates artificially low, greatly boosting stocks in multiple ways. QE left bond yields uncompetitive with stock dividends, “justified” extreme stock overvaluations, and fueled epic stock buybacks.
QT threatens to reverse all that, restoring interest rates to more-normal levels. That will ultimately wreak havoc in stock markets heavily dependent on anomalous suppressed interest rates. Rising bond yields will attract back income-seeking investors, sucking capital out of far-riskier dividend-paying stocks. And higher rates will make it much more expensive for corporations to borrow money to buy back their own stocks.
In order to grasp QT’s dire threat to these stock markets, we have to understand how they got way up here. This first chart superimposes the flagship US S&P 500 broad-market stock index (SPX) over the Fed’s balance sheet since 2009, the entire span of this monster stock bull. The orange line is the Fed’s total balance sheet, inside which is stacked total US Treasury QE in red on top of mortgage-bond QE in yellow.
This is the big-picture overview of almost the entire modern QE era, which started in late 2008 in response to the first stock panic in a century. In a single month ending in late October 2008, the SPX plummeted a catastrophic 30.0%! The Fed panicked as stocks cratered, fearing that a colossal negative wealth effect would paralyze our country. If Americans’ spending slowed enough, it would literally trigger a depression.
So the Fed slashed its federal-funds rate aggressively, going to zero in mid-December 2008. Once a zero-interest-rate policy is hit, no further rate cuts are possible. So the Federal Reserve proverbially fired up its printing presses to create vast amounts of new money out of thin air. Euphemistically called quantitative easing, those conjured dollars were plowed into bonds to force other interest rates down to artificial lows.
This Fed-QE era ran from late 2008 to late 2014, and the stock markets ominously mirrored the growth in the Fed’s balance sheet. When various QE campaigns were in force buying bonds to stack on its books, the stock markets relentlessly climbed. But whenever QE paused between campaigns, the SPX either corrected or stalled out. The Fed’s wildly-unprecedented QE money printing directly fueled a massive stock bull!
In 2015 and most of 2016 without new QE bond buying, the stock markets ground sideways and started to suffer corrections again. They only decisively broke free from that no-QE funk following Trump’s surprise election victory in November 2016. Hopes for big tax cuts soon drove enough greedy sentiment to finally overcome the lack of QE momentum. That blasted stock markets deep into record territory on many fronts.
While the Fed had stopped printing money to buy bonds in late 2014, it inexplicably waited several years until late 2017 to finally start unwinding that epic QE. The QT era started a year ago and has accelerated strongly in 2018. The euphoric stock markets are ignoring the Fed’s shrinking balance sheet for now, but it’s only a matter of time until QT stokes serious selling. That’s when stocks’ long-overdue reckoning will start.
Before digging deeper into QT’s very-bearish implications, let’s consider the QE era between roughly 2009 to 2015. This chart is one of the most-damning in stock-market history, showing how the SPX’s bull market perfectly mirrored the Fed’s balance sheet! QE literally levitated the stock markets, pushing them inexorably higher while short-circuiting normal healthy corrections. Selling only returned between QE campaigns.
What would later become known as QE1 started in late November 2008, with the Fed announcing $500b of buying in mortgage-backed securities and $100b in agency debt. In the first 8 months of 2008 before that stock panic, the Fed’s balance sheet averaged $849b. But by mid-November it had skyrocketed 152% to $2173b in just 11 weeks on the Fed’s frantic emergency measures to respond to that stock panic!
That extreme stock selling didn’t finally exhaust itself until March 2009, after the SPX had plunged 56.8% in just 1.4 years in a wicked bear market. While stocks normally surge out of panics, the SPX was down another 25.1% year-to-date due to fears of crushing income-tax hikes from Obama’s new administration. So a terrified Fed dramatically expanded QE1 in mid-March, spinning up its printing presses to high speed.
In QE1X the Fed pledged to buy another $750b of MBSs to force mortgage rates lower to keep the US housing sector moving. It is a key driver of national economic activity. The Fed also said it would double its agency-debt purchases with another $100b of buying. But the really stunning development was the Fed’s first-ever declaration of extensive direct monetization of US Treasury bonds to the tune of $300b.
That’s the kind of thing you see in banana republics leading to hyper-inflation, local central banks printing new money to buy up their government’s debt! That enables the government to run huge deficit spending, greatly distorting normal interest-rate signals that limit living beyond means. Together QE1 and QE1X totaled $1750b. The SPX soared 79.9% higher at best in essentially that QE1 span in a giant post-panic bounce.
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