What about QT? Has everyone forgotten about QT?
That’s one (among several) questions BofA’s Savita Subramanian wants answered.
The relationship between Fed bond-buying and equity markets is difficult to establish mathematically, but certainly not conceptually. Harley Bassman captured it well: “Clever quants will say a statistically significant mathematical correlation doesn’t exist between money creation and financial asset prices. But who are you going to believe, them or your lying eyes?”
The reference, of course, was to the ubiquitous chart of the Fed’s balance sheet overlaid with equity prices. The figure on the left (below) is a snapshot as things stood when the S&P was perched at record highs in January.
The slightly more nuanced figure on the right (above) illustrates the same point.
In light of the myriad idiosyncratic factors driving 2022’s fierce cross-asset crosscurrents, I’d argue there’s not much to be gleaned from analyzing this year’s equity performance through the lens of the truncated taper and nascent balance sheet runoff. Not yet. QT has only just began and disentangling the equity drag from reduced Fed liquidity versus what’s attributable to the myriad other factors pushing and pulling stocks during the most tumultuous period since Lehman, is impossible.
But BofA’s Subramanian is one “clever quant” (to channel Bassman) who thinks this debate is worth rekindling. She called it “the elephant in the room.” Over the past decade, half of the change in the S&P’s multiple was attributable to QE (figure on the right, below).
The figure on the left (above) shows the diminished role of fundamentals in explaining stock returns in the post-GFC era.
If QE mattered that much, “shouldn’t QT matter too?” Subramanian wondered. She cited the historical relationship between Fed balance sheet expansion and multiples in suggesting that QT, as envisioned, implies somewhere in the neighborhood of a 200-point drag on the S&P. Through next year, the impact should be -7%.
She posed another question: “The earnings impact from QE (low interest expense) has been unequivocally positive [so] could a reversal be anything but negative?” It’s not quite as simple as that, but Subramanian’s point stands.
Finally, she reminded market participants that QE is subject to the law of diminishing returns, “requiring more and more dollars to drive risk rallies.” That, she said, “means that even if the Fed dialed QE back up, the risk response would be muted at best.”
I’ve been wondering why the fed doesn’t push harder on balance sheet reduction if the financial markets are so upbeat?
Remember that Treasury market liquidity hasn’t been anyone’s definition of great lately. And notwithstanding the SRF, “ample reserves” is still a moving target, much like the neutral rate and any number of other nebulous thresholds. Of course, we’re nowhere near reserve scarcity, but Treasury market functioning is crucial. One person who knows that better than anyone is Zoltan Pozsar, which is why his tongue-in-cheek suggestion (in February) that the Fed abruptly start actively selling Treasurys with no warning re: the size or frequency or pace came across as disingenuous. Arguably, QT predictability is more important than predictably on the path of the policy rate. Friction in the Treasury market overrides all other concerns, period. Inflation included. If the UST market isn’t functioning correctly, the world stops spinning, almost literally. So, the last thing they want to do is accidentally undercut market functioning, because that’d just mean they’d be forced to intervene again immediately. None of that is to suggest (at all) that you’re wrong. You’re exactly right. And some of what I’ve just said is a straw man to the extent there are no indications that the market isn’t functioning properly. Volatility and illiquidity doesn’t necessarily mean something’s “wrong,” per se. The point is just to remind folks of the risks.
Finally! It’s as if no one remembers QT is happening. Goldman can talk about the size of the corporate bid all they want, but they ignore that QT will more than cancel that out. (I know, stocks not bonds, but unlike the transmission mechanism from Wall Street to Main street, transmission between stocks and bonds is well nigh frictionless.)
You’re right, it’s slipping off the radar. Psychologically easier to be bullish at these murky inflection points because “hope springs eternal” plus #recencybias. Keep the faith.
Qt ramps up to 95B in September.
When QT ramps up to 95B in September, won’t the Fed “engineer” an equal and offsetting reduction in ONRRP (currently $2.2T)????
One of the biggest risks facing us all is if the Republicans get in control again. Shortly afterwards anyone with a lick of sense won’t stand a chance of remaining in or getting any of the crucially important government positions.
I agree with Libero, starting in September the effect should become noticeable. Back in 2018, “W” mentioned in one of his articles that put options on SPX were profitable on the days that Fed holdings matured during that QT cycle.
My favorite analyst is the late William Goldman: “follow the money”, and for this thread, “nobody knows anything”.