Ominously for the stock markets, the Federal Reserve is warning that quantitative tightening is coming later this year. The Fed is on the verge of starting to drain its vast seas of new money conjured out of thin air over the past decade or so. The looming end of this radically-unprecedented easy-money era is exceedingly bearish for these lofty stock markets, which have been grossly inflated for years by Fed QE.
Way back in December 2008, the first US stock panic in an entire century left the Fed frantic. Fearful of an extreme negative wealth effect spawning another depression, the Fed quickly forced its benchmark federal-funds rate to zero. Once that zero-interest-rate policy had been implemented, no more rate cuts were practical. ZIRP is terribly disruptive economically, fueling huge distortions. But negative rates are far worse.
So instead of turning ZIRP to NIRP like the European Central Bank in June 2014 and the Bank of Japan in January 2016, the Fed chose a different unconventional-monetary-policy path. Just before it went full ZIRP in late 2008, it had started quantitative easing. Despite this fancy name, QE is nothing more than old-fashioned central-bank money printing. The Fed spun up its printing presses at wildly-unprecedented rates.
Literally trillions of dollars were created from nothing and used to buy bonds. This extreme measure was known all throughout history as debt monetization. Euphemistically calling it QE sounds so innocuous, leave it to economists to hide what’s really going on behind big words. Injecting such vast sums of new money into the US economy had never before been attempted, and the resulting aberrations were epic.
The chief among them was levitating the US stock markets even though the Fed was monetizing bonds, not stocks. This happened via two primary mechanisms. The Fed’s bond buying forced interest rates to extreme artificial lows. So traditional bond investors seeking income from yields were effectively bullied into far-riskier dividend-paying stocks instead. There’s no doubt boosting stock markets was QE’s intention.
The stock-market wealth effect is powerful, permeating the entire US economy. In just one single month leading into late-October 2008, the benchmark S&P 500 stock index had plummeted 30.0%! Americans were terrified, so consumers and businesses alike rapidly pulled in their horns. With stocks seemingly in a death spiral, they had no confidence in the future to spend. The Fed feared the economy grinding to a halt.
While QE directly lifted stocks by sucking investment capital out of bonds newly saddled with record-low yields, a secondary indirect QE impact proved more important. US corporations took advantage of the Fed-manipulated extreme interest-rate lows to borrow aggressively. But instead of investing all this easy cheap capital into growing their businesses and creating jobs, they squandered most of it on stock buybacks.
QE’s super-low borrowing costs fueled a stock-buyback binge vastly greater than anything seen before in world history. Literally trillions of dollars were borrowed by elite S&P 500 US corporations to repurchase their own shares! This was pure financial manipulation, boosting stock prices through higher demand while reducing shares outstanding. That made corporate earnings look much more favorable on a per-share basis.
Incredibly QE-fueled corporate stock buybacks have proven the only net source of stock-market capital inflows in this entire bull market since March 2009! Elite Wall Street banks have published many studies on this. Without the debt-funded stock-buyback frenzy only possible through QE’s record-low borrowing rates, this massive near-record bull wouldn’t even exist. Corporations were the only buyers of their stocks.
Just this month, Credit Suisse reported “one of the major features of the US equity market since the low in 2009 is that the US corporate sector has bought 18% of market cap, while institutions have sold 7% of market cap.” Both institutional and individual investors have been net sellers since the stock panic, only the corporations have been net buyers. So quite literally, without QE this anomalous bull never would’ve happened!
Smug Fed officials have taken countless victory laps on QE, declaring this biggest monetary experiment in all of world history a great success. But until those extreme bond monetizations are fully unwound via quantitative tightening, the fat lady has yet to sing on QE’s ultimate impact. If QT’s resulting interest-rate rises make bonds competitive for income again, and retard corporate stock buybacks, stocks are in dire trouble.
The total scope of QE is unfathomably large. What was originally promised to be a temporary measure in the bowels of a once-in-a-century stock panic quickly became quasi-permanent. The Fed didn’t just keep QE in place, but expanded it multiple times over the years. QT’s unprecedented threat to today’s lofty Fed-levitated stock markets can’t be fully appreciated without understanding the QE that generated this mess.
When the Fed creates new money to inject into the economy via bond purchases, those bonds are held on its balance sheet. This chart shows the Fed’s total balance sheet in orange. Stacked within it are the Fed’s total holdings of US Treasuries in red sitting on top of mortgage-backed securities in yellow. Way back in QE1 before it dared monetize Treasuries, the Fed also bought government agency debt in green.
Prior to the Fed birthing quantitative easing in late 2008 during that brutal stock panic, the Fed’s balance sheet had been at $849b. Then came the original QE followed by its expansion, QE2 with its own later expansion, Operation Twist and its expansion, and the unprecedented open-ended QE3 trailed by its own expansion. Together they ballooned the Fed’s balance sheet to a mind-boggling $4474b by February 2015!
In just 6.7 years, the Fed’s QE had collectively more than quintupled its balance sheet! A staggering $3624b of bond monetizations with money newly conjured out of thin air made for 427% balance-sheet growth. We are talking about $3.6t of QE here, so no superlative is too dramatic to describe how big it is. QE’s sheer gargantuan-ness explains why this Fed-easy-money-fueled stock-market bull has been so huge.
In the 8.4 years between March 2009 when QE1 was nearly tripled to late-July 2017, the S&P 500 has powered an astonishing 266.3% higher. That is far beyond normal bull-market stature. This makes for the second-longest and third-largest bull market in US history, all fueled by QE-spawned corporate stock buybacks. Just this week it overtook the previous third-largest bull, right under 266% back in the early 1950s.
The Fed finally ceased conjuring new money out of thin air to monetize bonds in October 2014 when it had fully tapered QE3. Most investors seem to think that was the end of the QE story, but it was really only half-time. Once again QE really isn’t over, its full economic impact cannot be understood, until this extreme monetary policy is fully unwound and reversed via QT. And that is finally due to start later this year.
Since the Fed’s balance sheet peaked just after QE3, there’s been no meaningful bond selling at all yet. The latest read from the Fed on its own grotesquely-bloated balance sheet showed it at $4440b in late July. That’s down merely 0.7% from its peak 2.4 years earlier! Just like the US stock markets had never experienced QE before early 2009, they’ve never faced QT before. Stock investors ought to be terrified of it.
This next chart shows why. It superimposes that benchmark S&P 500 stock-market index (SPX) on the Fed’s extreme balance sheet. This chart is incredibly damning, exposing the great folly of central banks monetizing bonds. The stock markets closely tracked the Fed’s balance-sheet expansion under those various QE campaigns. Make no mistake, QT looks every bit as bearish for stocks as QE proved bullish!
The stock markets should’ve bottomed in October 2008, after that panic selling climax bashed the SPX 30.0% lower in a single month. Over the next 6 trading days, the SPX indeed rocketed up 18.5% to peak on Election Day. Then Obama won, and started talking about big tax hikes and effectively nationalizing US healthcare. So over the next dozen trading days following Election Day, the SPX plunged another 25.2%!
Fed officials panicked, and birthed what would later prove QE1 a few trading days later. QE has always had heavy political overtones. The combination of ZIRP hammering the short end of the yield curve and QE blasting down the long end removed all free-market restraints on US government spending. Since interest-rate signals were short-circuited by the Fed, the Obama Administration easily doubled the US debt.
Those same Obama big-tax-hike and healthcare-nationalization fears in early 2009 drove stock markets to one final low in March. At its next FOMC meeting just 7 trading days later, the Fed nearly tripled its QE1 purchase plans with the QE1X expansion. That was the first time the Fed started to monetize the US government’s Treasury debt, directly financing record deficit spending. The stock markets soared on that.
When the full QE1 campaign including its expansion had ended in mid-2010, the Fed’s balance-sheet growth naturally stalled. Without those easy-money inflows, the SPX immediately corrected hard. It was already becoming apparent stock markets were addicted to QE. Soon after the SPX dropped 16.0% in a couple months, the FOMC launched QE2 to keep the party going. Stocks started surging again, despite QE2’s quirks.
The original QE2 wasn’t new quantitative easing, it didn’t grow the Fed’s balance sheet. All it did was convert mortgage-backed bonds into Treasuries. But that was soon followed by QE2X, which proved a huge escalation. The $600b in new direct Treasury monetizations announced doubled QE’s total buying in that arena. The stock markets once again soared in lockstep with the Fed’s balance sheet ballooning.
The full QE2 campaign ran its course in mid-2011, so the Fed’s balance sheet again stalled out. Right on cue, the SPX corrected hard. It plunged 19.4% nearly entering a new bear market! The Fed was really worried the stock markets would roll over into that bear without QE’s boost, so the FOMC birthed Operation Twist at that correction’s bottom. That was designed to slowly wean the stock markets off QE.
Twist wasn’t new QE, it just shifted $667b of Treasuries from short-term to long-term to hold down the long rates. So the SPX rallied again with the mounting perception the Fed was getting in the business of backstopping stock markets. If the Fed wouldn’t let them sell off, then why worry about anything? Twist also greatly forced down corporate borrowing costs, really accelerating the already-big stock buybacks.
Once again politics came into play with the launch of QE3. TwistX had recently ended, and the Fed was under heavy fire from Republican lawmakers heading into the 2012 elections. They were furious that QE had enabled record deficit spending and national-debt growth under Obama, so they threatened to strip the Fed of its coveted independence. The Fed retaliated by launching QE3 with stock markets near highs.
Stock-market fortunes heavily sway the outcomes of US presidential elections, really affecting how swing voters feel economically. The stock markets were looking toppy in late summer 2012, and weaker stock markets reduced the incumbent Democrats’ chances of winning and protecting the easy Fed. So out of the blue in September 2012 less than 8 weeks before Election Day, the Fed birthed QE3 and goosed stocks again.
The resulting rally indeed resulted in a second Obama victory, immediately removing the Republicans’ threats of reining in the Fed. And QE3 was radically different from QE1 and QE2 in that it was open-ended. After seeing the ends of QE1 and QE2 both result in major stock corrections, the Fed didn’t want to risk QE3 doing the same. So QE3’s monetizations had no predetermined sizes or end dates like earlier campaigns’.
QE3 was soon expanded in December 2012, so the Fed’s balance sheet started rocketing higher again in 2013. Once again the SPX perfectly mirrored the Fed’s bond-monetization growth! QE3’s advent was when the stock markets started getting extremely distorted. Every time they started to sell off in any normal healthy pullback or correction, top Fed officials would rush to say QE3 could be expanded anytime.
Stock traders came to believe the Fed was backstopping the stock markets, so they ignored all usual fundamental, technical, and sentimental topping signals to buy every dip. The resulting SPX levitation from 2013 to 2015 after QE3 was finally fully tapered and the Fed’s balance sheet stopped growing was wildly unprecedented in all of history. This stock bull’s advance closely tracked the Fed’s balance sheet!
All investors need to study and understand the stock markets’ tight relationship with the Fed’s bond holdings. QE directly fueled and drove this extreme stock bull, so the unwinding of QE via QT is something to be feared. Based on stock-market action during the entire QE era, it’s hard to imagine stocks staying high as the Fed soon starts to unwind and reverse QE. Monetary creation will shift to monetary destruction.
Soon after QE3 ended in October 2014, this stock bull topped not too much higher in May 2015. Then the SPX suffered two corrections in rapid succession, 12.4% in mid-2015 and 13.3% in early 2016. That was unlike anything seen in the QE era, showing the stock markets starting to roll over into their overdue Fed-delayed bear. Stock markets traded sideways to lower for nearly 14 months, until that surprise Brexit vote.
In late June 2016, the British people surprised by courageously voting to leave the EU and retake their own sovereignty. The stock markets sold off hard initially on that surprise, but then started surging higher on hopes that would force central banks to aggressively ease again! That hope-for-CB-intervention rally soon fizzled though, with the SPX grinding lower until Trump’s surprise election win early last November.
The resulting Trumphoria rally since is another extreme anomaly, on hopes for big tax cuts soon instead of more Fed QE. Almost all the big daily rallies since the election happened on days when political news seemed to signal those fabled Trump tax cuts were really coming. Without Trumphoria, the SPX would still be stalled near 2100 right where it was when the Fed’s balance sheet stopped expanding a couple years earlier.
Traders are starting to understand that the bickering Republican lawmakers in Congress might not come together long enough to pass those Trump tax cuts. And without massive tax relief, this whole rally since the election is built on a foundation of sand. The stock markets were already trading way up near bubble valuations before Trump won, and have stayed in that dangerous toppy territory since. And now QT cometh!
The Fed started talking about beginning quantitative tightening later this year at its early-May meeting, as subsequently revealed in the minutes. Then at the next FOMC meeting in mid-June, QT was really made official within the FOMC statement. It warned, “The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.”
The Fed even went into great detail, “This program, which would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities, is described in the accompanying addendum to the Committee’s Policy Normalization Principles and Plans.” That attached document explained how the FOMC is expecting to actually implement quantitative tightening.
No start date was specified, but Fedspeak from top FOMC officials has implied it will likely happen at the next FOMC meeting followed by a Yellen press conference in mid-September. Wall Street expects the Fed to soften the blow with no rate hike at that meeting. QT will likely be formally announced, to start the next month as Q4 dawns. The FOMC laid out plans to begin QT small, but it will quickly grow to massive levels.
QT won’t involve active bond selling, instead the Fed will let maturing Treasuries and mortgage-backed bonds roll off its bloated balance sheet. These rolloffs will initially be capped at just $6b per month for Treasuries and $4b per month for MBSs. Every quarter, these monthly caps will be raised by $6b and $4b respectively until they reach $30b and $20b per month. That makes for total monthly QT projected at $50b!
That’s astounding, vastly more aggressive than Fed watchers expected from this uber-dovish Fed. If it sticks to plan, that full $50b-per-month QT would be in place by the end of 2018. This is really going to happen. Janet Yellen’s term ends in early February 2018, and she really wants to get QT underway on her watch. But she will be out of office well before QT grows big enough to obliterate QE-levitated stocks.
A $50b-per-month pace of quantitative tightening works out to $600b per year! Remember the Fed has $3.6t of QE it would have to unwind to fully reverse it, which would take 6 years. That pace is roughly symmetrical with the 6.7 years all the QE campaigns collectively took. If the Fed’s extreme balance-sheet expansion during QE was so bullish for stocks, won’t a similar-paced contraction be super-bearish?
But this hyper-dovish Fed is far too cowardly to fully unwind QE, with top Fed officials often pointing out the Fed’s balance sheet will remain much bigger than pre-panic levels. General consensus among the elite Wall Street analysts who watch the Fed full-time is that a half-unwind is coming, $1.8t of QT on that $3.6t of QE. At the Fed’s projected $600b-per-year pace, that would only take a few years to execute.
The implications for these near-bubble stock markets artificially inflated by the Fed are staggering. That half-unwind would shrink the Fed’s balance sheet back to April 2011 levels of $2630b. Back then before the end of QE2 and QE3’s stock rocket fuel, the SPX merely traded at 1330. That’s 46% under the recent all-time record high! Destroying $1.8t of capital that levitated the stock markets is going to really hurt.
Quantitative tightening is hostile for stock markets, a fierce headwind. Less Fed bond buying as it lets bonds roll off its books means higher interest rates coming. That will raise bond yields, restoring some of their competitiveness with far-riskier dividend-paying stocks. Plenty of income-seeking bond investors forced into stocks by QE will sell stocks to return to bonds under QT. Stocks will no longer be the only game in town.
Higher rates will also greatly retard that extreme corporate-stock-buyback spree that directly levitated the stock markets. Corporations will not only find it more expensive to keep borrowing to manipulate their own stock prices higher, but much of their existing trillions of debt under QE will become costlier to service. They will greatly reduce their buybacks, instead allocating any available capital to paying down QE debt.
Remember corporate stock buybacks have been the only source of net buying for this entire monster bull of the QE era. So if QT significantly slows or even reverses these massive buybacks, watch out below for the stock markets! But surely the Fed will stop QT if the stock markets drift lower or correct hard nearing bear-market territory, right? Maybe or maybe not, but by that point it might already be too late to matter.
QE3 had a much-greater impact on the stock markets than QE1 and QE2 not just because of its size, but due to its influence on trader psychology. Once QT is launched later this year, there will be no doubt that the Fed no longer has stock traders’ backs. The Fed will shift from being viewed as friend to foe, and not even slowing or stopping QT will change that rapidly. QT headwinds will persist for years just like QE tailwinds.
If the FOMC gets worried that QT is crushing stock markets and stops it, that is very problematic too. It won’t only be a colossal hit to the Fed’s credibility, but traders will view a pause in QT as a sign the Fed has lost confidence in the US economy. That will motivate them to flee stocks all the faster, exacerbating any bearish sentiment. Once the Fed starts QT, it’s seriously committed. Stopping it could prove even worse.
The Fed won’t be blamed anyway. While QE absolutely levitated the stock markets as this chart proves, at the time QE wasn’t widely attributed. Instead traders naturally focused on short-term news, daily events that are used to rationalize stock-market up days. During QT the same thing will happen. Even if QT is driving the overall selling, down days will be explained at the time based on current newsflow instead of QT.
And once again politics will come into play surrounding QT too. This Fed remains highly political, with at least one top FOMC official donating to Clinton’s campaign in the last election. Yellen herself is a hardcore lifelong Democrat, often giving speeches with views that could come from any Democratic campaign. Consider how the Fed rate hikes in this latest cycle have played out relative to presidents, it’s pretty striking.
Despite soaring stock markets and good economic data, the Fed only hiked a single time while Obama was in office. And that was nearly 7 years into his term when there was no re-election risk! After that the Fed held fire for an entire year during the 2016 campaign, when it looked like a Fed-friendly Democrat would succeed Obama. Then just 5 weeks after Trump won, the Fed started hiking again. Aggressively.
It has now raised rates three times in less than 9 months since Trump’s victory! And now after years of delay under Obama, QT is coming under Trump. The FOMC very well understands how damaging QT will prove to stocks, and likely wants to pin the blame on Trump instead of its own QE. Weaker stock markets in coming years will lower the odds incumbent Republicans can keep their hold on Congress and the presidency.
Since Republican lawmakers remain very hostile to the Fed, still threatening to greatly neuter its power, the FOMC has every incentive to let the QT stock-bear aftermath unfold on Trump’s watch. Don’t be hasty to dismiss the Fed’s political angle here. Every major Fed decision for years now has closely tied in with the politics of the time. A QT-spawned stock bear before the coming elections could maintain Fed independence.
With quantitative tightening looming for the first time in history, investors really need to lighten up on their stock-heavy portfolios. A major new bear is long overdue anyway due to near-bubble valuations. Cash is king in bear markets, as its buying power increases as stock prices fall. Investors who hold cash through a 50% bear market can double their stock holdings at the bottom by buying back stocks at half price!
Put options on the leading SPY S&P 500 ETF can be used to hedge downside risks. They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.
Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early last year. If the stock markets indeed roll over into a new bear in 2017, gold’s coming gains should be much greater. And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains. Gold stocks rocketed 182% higher in 2016’s first half!
Absolutely essential in bear markets is cultivating excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will, so we can later sell high when few others can. While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.
The bottom line is the coming quantitative tightening is incredibly bearish for these stock markets that have been artificially levitated by quantitative easing. All the stock-bullish tailwinds from years of QE will reverse into fierce headwinds under QT. Higher interest rates will restore bonds’ competitiveness with stocks, and greatly retard corporate stock buybacks which were this outsized bull’s only meaningful driver.
The Fed’s monetary fire hose that injected trillions of dollars of freshly-conjured money into the markets for years will soon start sucking that capital back out. As the Fed’s QE giveth, the Fed’s QT taketh away. These QE-inflated stock markets are in serious trouble under QT, and the FOMC might not even care for political reasons. But even if it does, stopping QT after it begins could crush confidence accelerating the selling.
By Adam Hamilton
