Starting on Wednesday, the Federal Reserve will begin reducing its almost $9 trillion portfolio. This process is designed to supplement rate hikes as the Fed tries to get control of rampant inflation.
Analysts generally agree that while the precise impact can be debated, overall this process will serve as yet one more headwind for the stock market. As stocks suffered losses on Tuesday, and government bonds sold off, this is one more worry for a market already concerned with the prospect of a recession.
The purpose of quantitative tightening is to reduce the money supply to slow the economy in a predictable and controlled fashion, in much the opposite way to how quantitative easing is used to increase the money supply and fuel economic growth and activity. In the markets, it is seen as likely to drive up real or inflation-adjusted yields, which will make stocks somewhat less attractive. In addition, it will push up Treasury premia, the compensation that drives investors to to bear interest rate risks over the life of a bond.
Some think the timing is not right to begin quantitative tightening now, in a market which just flirted with bear territory. According to a survey by the American Association of Individual Investors, optimism about the stock markets immediate future is below 20%, the fourth time in seven weeks. Meanwhile inflation continues to impact prices all across the board.
Dan Eye, chief investment officer of Pittsburgh-based Fort Pitt Capital Group said, “I don’t think we know the impacts of QT just yet, especially since we haven’t done this slimming down of the balance sheet much in history. But it’s a safe bet to say that it pulls liquidity out of the market, and it’s reasonable to think that as liquidity is pulled out, it affects multiples in valuations to some degree.”
Regardless, the Fed will begin reducing its holdings of Treasury Securities, agency debt, and agency mortgage-backed securities by a total $47.5 billion per month for three months. After that the Fed will increase the amount being reduced to $95 billion each month. It is expected they will adjust their approach based upon conditions as the plan is carried out.
This will occur as maturing securities roll off the balance sheet of the Fed, and proceeds are not reinvested. The Wells Fargo Investment Institute predicts that starting in September, this will occur at, “a substantially faster and more aggressive” rate than the process which occurred in 2017.
The Wells Fargo Investment Institute calculates that the Fed’s balance sheet may be reduced by almost $1.5 trillion by the end of 2023, a reduction to around $7.5 trillion. It is expected this $1.5 trillion reduction will be equivalent to an additional 75-100 basis points of tightening. That would be at the same time the fed-funds rate is an expected 3.25% to 3.5%. The current target range of the fed-funds rate is 0.75% to 1%.
The institute added, “Quantitative tightening may add to upward pressure on real yields. Along with other forms of tightening in financial conditions, this represents a further headwind for risk assets.”
.All three major stock indexes finished lower on Tuesday, with the Dow down .67%, the S&P 500 down .63%, and the NASDAQ down ,41%. Meanwhile Bonds sold off across the board.