To The Moon

Since the wake of the global financial crisis of 2008, central banks around the world adopted unconventional monetary policies to stimulate economic growth and stabilize financial markets.

Quantitative Easing (QE) is such one policy used, which involved the large-scale purchase of financial assets by central banks. As economies recovered, central banks began to contemplate the unwinding of these measures, leading to the advent of Quantitative Tightening (QT).

While the intention behind QT is to normalize monetary policy, it poses significant risks to the stock market.

Understanding Quantitative Tightening

Quantitative Tightening is the process by which central banks reduce the size of their balance sheets by selling or allowing matured securities to roll off.

This is the inverse of Quantitative Easing, where central banks inject money into the financial system by purchasing assets. The main goal of QT is to prevent the economy from overheating, control inflation, and restore interest rates to more conventional levels.

Risks Associated with Quantitative Tightening

Market Volatility

One of the primary risks associated with QT is increased market volatility. As central banks unwind their balance sheets, it can lead to a reduction in liquidity and trigger abrupt movements in asset prices.

Investors, accustomed to a prolonged period of low interest rates and ample liquidity, may face challenges in adapting to the changing market dynamics.

Rising Interest Rates

QT often accompanies an increase in interest rates as central banks sell assets and reduce the money supply.

Higher interest rates can lead to higher borrowing costs for companies and consumers, potentially dampening economic activity. This, in turn, can negatively impact corporate earnings and stock valuations.

Global Impact

Quantitative Tightening by major central banks, particularly the U.S. Federal Reserve, can have widespread global repercussions.

Emerging markets, in particular, may face challenges as capital flows out in search of higher yields in developed markets, leading to currency depreciation and financial instability.

Debt Servicing Pressures

Companies and governments that have relied on low-interest rates to service their debt may face increased financial strain as interest rates rise.

This could lead to a rise in default rates and a negative impact on the credit markets, affecting the overall health of the stock market.

Here is another issue with Quantitative Tightening

Fed stops buying Treasuries on top of draining cash. This cause a concern that bond liquidity that could have been reinvested by the Fed will now being drained away from the financial system.

The old practice of always having a portion of its outstanding bonds rolled over by the Fed could no longer by counted on by the US Treasury. Instead, new private buyers must refinance it, and the future of the treasuries depends very much on whether the Treasury Department can control its spending.

As the Federal Reserve maintains high interest rates for a longer period of time, the pressure on fiscal interest expenditures has increased significantly.

As of October this year, the federal government’s interest expenditures accounted for 11% of total expenditures (12-month moving average).

Under the neutral scenario, the proportion of interest expenditures in GDP is expected to rise to 2.7% next year, and the proportion in total fiscal expenditures is expected to rise to 13%, both of which are lower than the high levels in the 1990s.

source: https://fiscaldata.treasury.gov/

This gives the Treasury Department some space, but the bipartisan decisions on next year's budget will still become a variable in the future Treasury market and further affect the Fed's QT process.

source: https://fiscaldata.treasury.gov/

Asset Price Corrections:

As central banks reduce their balance sheets, various asset classes may experience corrections. This could be particularly pronounced in markets that have experienced inflated prices due to prolonged periods of accommodative monetary policy.

We can see that the balance of the reverse repurchase window has been declining rapidly as planned for 2023. This is a sign that market liquidity is decreasing.

But if we look at the commercial banks’ reserves at the Fed, they have actually risen in 2023 which indicate that cash is declining at a slower rate than expected.

Mitigating the Risks

Transparent Communication

Central banks must communicate their QT plans clearly to minimize uncertainty in financial markets. Clear guidance can help investors make informed decisions and reduce the likelihood of panic selling.

Gradual Implementation

To minimize shocks to the financial system, central banks should consider a gradual and carefully calibrated approach to QT. Sudden and aggressive tightening measures can lead to market disruptions.

Monitoring Economic Indicators

Central banks should closely monitor economic indicators to assess the impact of QT on the broader economy. Adjustments to the pace of tightening can be made based on real-time economic data.

Summary

While Quantitative Tightening is a necessary step towards normalizing monetary policy, its risks on the stock market cannot be overlooked.

Striking the right balance between removing monetary stimulus and avoiding undue market disruptions is a delicate task.

Investors, policymakers, and central banks must work together to navigate these challenges and ensure a smooth transition to a post-QE era.

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Disclaimer: The analysis and result presented does not recommend or suggest any investing in the said stock. This is purely for Analysis.