How Will Markets React to the End of $6 Trillion QE4?
There have been four QE programs conducted by the Federal Reserve from the Global Financial Crisis in 2008 through March 2022. The Fed operates QE by purchasing treasuries, mortgage-backed securities and agency debt. By far the largest QE program was the most recent from March 2020 consisting of nearly $6 trillion in MBS and treasury purchases. We have had only one quantitative tightening period to evaluate and it corresponded to negative S&P 500 returns and very high market volatility.
The guidance I will be looking for at the next FOMC meeting, in addition to the Fed fund rate hikes, is how much time until quantitative tightening begins. Back in January we learned that the Fed discussed reducing their balance sheet "sooner than expected." Next, I will be looking at the schedule for asset unwind as was published in advance back in 2018 to allow the markets to try to absorb the reduced market liquidity. The reaction to the start of QT in 2018 led to the termination of VIX volatility funds and many VIX spikes over 20% that year. The initial tightening schedule by the Fed in the first part of 2018 of $30 billion in assets per month shows a very large VIX spike followed by dampening volatility through September. It was the subsequent hike in October to $50 billion in asset reduction per month that appeared to trigger more high volatility and the market correction that followed into December 2018. It was not until after the Fed halted tightening actions at the end of December that the market finally recovered. Currently the Fed holds a large percentage of the treasury market now estimated at over 25% into 2022. This high balance increases the risk that future tightening events may be longer and more severe than we experienced in 2018. The next most important set of data from the Federal Reserve, promised at a future meeting, will be the detailed schedule of the QT asset reduction program. How the Fed decides to drain liquidity from the market at the same time as they are raising interest rates will be a key discussion for another article update. There is no shortage of major economic factors that will continue to impact the market performance for 2022 and beyond. As I write this article, the Russian war in Ukraine continues and there is no certainty about when Russia will end their invasion or how much destruction will unfold in the coming weeks or months. Global sanctions ranging from oil, gas, grains, credit, shipping, and many basic materials have been put in place against Russia and the full economic impact is unknown. Inflation measures are at the highest levels in 40 years. The US GDP outlook is being revised lower and economic conditions are strained. This article provides some guidance about what the end of the largest QE program in U.S. history may mean to investors – and the potential impact of an imminent asset normalization policy from the Federal Reserve.