Sep 22, 2022 - Economy

What the Fed's "quantitative tightening" mission could mean for the markets

Total Federal Reserve assets
Data: FactSet; Chart: Axios Visuals

The worst year for stocks since 2008 could still get uglier, as the Fed's effort to pull potentially trillions of dollars out of financial markets hits full steam.

Driving the news: The Fed opened up the second front in its war against inflation in recent months, moving to shrink its stockpile of nearly $9 trillion worth of U.S. government bonds — a process known as quantitative tightening.

  • In September it upped the rate at which it's cutting its holdings, to nearly $100 billion a month.
  • The Fed also continues to lift short-term interest rates, delivering its third consecutive hike of 0.75 percentage points Wednesday.

Why it matters: The only previous attempt by the Fed to simultaneously raise rates and decrease its holdings of government bonds coincided with an ugly 20% stock market sell-off in late 2018.

  • The S&P 500 is already down 21% from its peak early this year, after the Fed launched its effort to crush inflation by lifting short-term interest rates.
  • The big question: With quantitative tightening just ramping up, is the other shoe about to drop on the market?

What they're saying: "Less support for the bond market and contraction in the financial system creates another set of headwinds for the economy and financial markets," wrote John Lynch, chief investment officer at Comerica Wealth Management.

The big picture: When the economy went into a COVID-related nosedive in early 2020, the Fed started pumping newly created dollars into financial markets as part of its efforts to make sure the economy didn't become a smoldering crater.

  • It did this by buying more than $4 trillion worth of Treasury bonds and government-backed mortgage bonds.
  • Buying those bonds lowers long-term interest rates, which in turn lowers mortgage and auto loan rates, coaxing Americans into spending their cash instead of clinging to it in scary times.
  • The plan largely worked, and auto and home sales surged during the crisis. (Some also blame it for adding to the current inflation issues.)

Between the lines: A side effect of the plan was the stock market's record growth, as the flood of newly created money sloshed through the system.

  • The stock market rose 114% between March 2020, when the Fed announced its quantitative easing program, and its peak in January 2022.
  • Some analysts think that the impact of the Fed's money printing and bond buying programs might have influenced the manic mood of the markets — meme stocks! SPACs! crypto! NFTs! — over the last couple of years, in which every slight downturn for stocks was met with traders who rushed to "buy the dip."

The bottom line: Now that the Fed is shrinking its balance sheet — effectively pulling a cool $100 billion out of financial markets every month — some expect the massive pandemic-era tailwind to turn into a massive headwind for an already troubled stock market.

  • "The idea of buying dips became firmly ingrained in investors during the post-COVID jump from mid-2020 through 2021. Many viewed it as a nearly foolproof strategy," wrote Steve Sosnick, chief strategist at Interactive Brokers in Greenwich, Connecticut, in a recent note to clients.
  • "What made it work was the flow of money unleashed by a combination of rate cuts, quantitative easing, and fiscal stimulus."
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