Not only did we invent a new acronym – QT (stands for Quantitative Tightening, in case you are wondering) – to capture the Fed’s unwinding of its large balance sheet, we also attributed extraordinary importance to the Fed’s implementation of QT, as it was going to create all means of havoc in asset prices.
The thinking went as follows: If the old acronym QE – Quantitative Easing – was so helpful to the asset markets, the unwinding of the Fed balance sheet – QT – should cause trouble in the markets.
On the surface, all of this makes sense. If you look at the period QE was in effect in all three of its iterations, basically December 2008 to December 2014, it worked. It was followed by periods of good performance of the asset markets, and when the Fed talked about scaling back its QE policies, the market threw a Taper Tantrum, causing U.S. Treasury yields to surge and markets to wobble.
Fed Balance Sheet and Asset Prices: No Link
One could, therefore, be excused if one drew the conclusion that the Fed or all central banks buying assets by paying for them with newly minted reserve liquidity created a crowding-out effect in the asset markets, and it was this liquidity pumping and crowding out that caused asset prices to go up. A logical extension of this line of thinking, then, is that as the Fed and other central banks go down the path of QT, the markets will become less liquid and drown in newly dumped bonds.
It makes logical sense. However, in my opinion, much like the theory that supply and demand of U.S. Treasuries determines U.S. 10-year rates, the Fed balance sheet theory of asset prices is just not true.
There is no empirical analysis that establishes the correlation of asset prices and the size of the Fed’s balance sheet alone. While the data sets are relatively short and driven by only one regime, the paucity of established empirical correlation between asset prices and the size of the balance sheet alone is extraordinarily glaring.
The reason for that lack of empirical data is actually quite simple: Quantitative Easing clearly works on supporting asset prices, but it works not because of the size of the Fed’s balance sheet. Instead, it works because it signals to the market that the Fed intends to keep rates low for an extended period. So, it’s not about the balance sheet. Instead it is all about providing guidance about future Fed policy. It is really that simple.
Don’t Fear QT
Similarly, the correct interpretation of the market implication of the QT in today’s environment is that it provides a signal about Fed policy. And as long as Fed policy was to tighten, which was in congruence with the unwinding of its balance sheet, it had negative implications for asset prices.
However, if the new Fed policy is to not tighten anymore – as every member of the Federal Open Market Committee, including all the hawks seems to be indicating – then it is that guidance, rather than the unwinding of the balance sheet, that is going to be the market driver.
While this may seem like a mere academic quarrel, it is not.
It is quite likely that the Fed balance sheet unwind may continue for some time, but the Fed remains on pause and continues to tell us repeatedly that they remain on pause. In that environment, we believe asset prices can continue to do well, balance sheet unwind notwithstanding.
In reality though, while it may not seem like it today, it will prove to be a spurious argument. If the future Fed policy is to not tighten – or ease, as the markets seem to be getting to – the balance sheet unwind cannot continue, precisely because it would be a bad or incongruent signal for the markets about future Fed policy. It would not be helpful to the Fed, and the unwind will actually stop. I believe that happens before the year is out.
In the interim, don’t fear the Fed balance sheet unwind – the QT. Focus on Fed policy. And if that is changing as we and the markets believe, asset prices can do well. Consider buying global equities, especially emerging market equities.