What Quantitative Tightening Means For The Stock Market
For much of the last decade, quantitative easing (or QE) was the dominant monetary policy strategy of central banks. QE is an expansionary policy that central banks turned to when their own policy interest rates were already near zero. It’s seen as unconventional as critics often argue it’s a form of tacitly printing money. In undertaking QE, the Central Bank creates money electronically and uses it to buy assets (usually government bonds) from the market. This increases the amount of money in the financial system, encouraging banks to lend more and pushing interest rates lower, which drives more lending to consumers and businesses. If businesses use the money to invest and consumers spend more, this can give the economy a boost.
Multiple rounds of bond-buying by central banks since the financial crisis of 2007-09 have yielded some understanding of how QE actually impacts financial markets – it signals a commitment to ultra-low interest rates, suppresses long-term rates and supports liquidity, ensuring that markets operate smoothly. Indeed, over the past ten years, asset returns have displayed a high correlation with central bank purchases. So what about quantitative tightening (QT), the reverse of QE?
For starters, QT, when central banks reduce their balance sheets either by letting bonds mature without replacement or by simply curtailing bond-buying, is a far rarer policy. So naturally, investors are wondering; what effect does QT have on the already volatile market?
Very little it seems.
One reason is that while the size of this balance sheet reduction is large, it’s set to be quite predictable, with reductions happening in a regular manner, almost regardless of market conditions. The stock market tends to react more sensitively to unpredictability and surprises, leaving QT largely ignored amid the situation with federal interest rates, where central bank policy has been rapidly changing and very dependent on incoming data.
Furthermore, the extent of QT is likely to be much smaller than of QE, thus limiting its effect on long term interest rates, though it’s likely to still be a drag on growth. Adding to that, some of the Fed’s bond holdings have long terms to maturity, making the overall process of QT likely to move slowly across years. Janet Yellen once compared QT to watching paint dry.
And finally, the central bank balance sheet itself is just one of many factors driving cross-asset performance. Research from Morgan Stanley has shown that most of the stock market moves over the last 12 years are explained by factors other than the central bank balance sheet.
The information contained in this article is not intended and should not be used or construed as an offer to sell, or a solicitation of any offer to buy, securities of any fund or other investment product in any jurisdiction. The information in this article is not intended and should not be construed as investment, tax, legal, financial or other advice. Past performance is not indicative of future performance.
