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Capital Markets Face Difficult Test 


Richard Barnett, CFA

From theory to practice

While working towards my economics degree in college, I vaguely remember reading something about “quantitative easing”, a central bank technique to lower interest rates and stimulate the economy by injecting liquidity through monetary operations. So when I first heard talk about Quantitative Easing (QE) around the end of 2008, I wasn’t sure if it had ever been done before, how it worked, or even if it would work.

However, I didn’t need to dust off my economics textbooks, since we got a real-world lesson in QE, which officially started in November of 2008 and continued until the beginning of March 2022. To answer my first question, this was the first time QE had been deployed in the US. After that, big QE programs were rolled out in 2010, 2012, and 2020. 

QE and QT

Now that the era of QE is at an end, its opposite is starting, Quantitative Tightening (QT). But exactly what is QT? 

QT is designed to reduce the amount of liquidity in the financial system, and replace the Federal Reserve as the largest purchaser of fixed income securities with a much broader set of market participants. With regard to my second question, the mechanics of QE and QT are beyond the scope of this short article, so we’ll set that one aside for now. The primary objective of QT is to shrink the size of the Fed’s balance sheet and put more bonds in circulation in the capital markets. Fewer securities held by the Fed mean more securities held by other market participants. 

In essence, the Fed is providing less support and liquidity to the credit markets, nudging the markets to function on their own.  

While there are arguments over whether the Fed overstimulated the economy and waited too long to reverse course, to answer my third question, QE did work. The effect of the Fed buying massive quantities of fixed income securities and holding them on the balance reduced short-term interest rates.  

In response first to the global financial crisis, then to the COVID tsunami, the Fed has a Zero Interest Rate Policy (ZIRP). This policy can be seen here, where the blue line plots the Federal funds rate– the rate at which banks can borrow from the Fed–and the red line plots the size of the Fed’s balance sheet. 

The effective federal funds rate (blue line, left scale), remained near zero for several years.

The total size of the Fed’s balance sheet (red line, right scale), rose from less than $900 billion before the recession (marked by the shaded area) to about $4.5 trillion at the balance sheet’s peak.

Double Trouble

The macroeconomic outlook is complicated by the fact that the Fed and the global economy are tightening at the same time. Economists track a variety of financial conditions that are shown to have a direct correlation to GDP, including; interest rates, exchange rates, credit spreads, and equity valuations, to determine the cost and availability of credit in the economy. Heading into the second half of 2022, these financial conditions are tightening, with a steep climb to levels seen in the heights of the global pandemic.  

Fed pivot

With inflation at 40-year highs, confirmed by the higher-than-expected May CPI print at 8.6% year-over-year, the Fed clearly had to act. They started with a .50% Fed funds increase in May, followed by an additional .75% in June, a decision that seemed to have come at the last minute with market pundits calling for a stronger response. The European Central Bank has also started tightening, announcing plans to end bond buying and hike .25% in July, followed by a .50% hike in September if inflation does tamper down.  

Markets are behaving predictably in the face of dual tightening by the Fed and the economy, exacerbated by the war in Ukraine, with a significant selloff this year.

A post ZIRP equilibrium

As with many macroeconomic relationships, it is hard to separate the effects of QT and tightening financial conditions since they are happening simultaneously. Anticipation of more QT may be one of the factors driving the negative change in financial conditions. 

In the long-term context of healthy capital markets, the Fed needs to tighten, not only to fight inflation, but to reconnect interest rates and market forces, and ensure the economy does not get permanently addicted to artificially low rates. Another advantage of the Fed reducing its balance sheet is that it will be in a better position to handle a future crisis. While spiking inflation forced the Fed’s hand to begin tightening, as we are seeing now, there is no good time to take the punch bowl away from the party. A recent study by the Fed concluded that a $2.5 trillion reduction in the balance sheet over the next few years would increase the Fed funds rate by 0.5%. This seems conservative based on recent Fed actions. 

While there is no sugarcoating investor losses this year, we recognize that markets occasionally have to go through painful transition periods when macroeconomic conditions dramatically change. We also know that there have been many periods in the past when the capital markets thrived during higher interest rate regimes. In fact, a ZIRP is the exception, not the rule. Higher rates encourage saving, benefit fixed income investors with higher yields, and do not inhibit the long-term growth and attractive returns of risk assets, including public equities and private capital markets over the long-term.

Sources: US Federal Reserve Board of Governors, Reuters, Goldman Sachs

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