This week’s landmark Federal Open Market Committee decision to launch quantitative tightening is one of the most-important and most-consequential actions in the Federal Reserve’s entire 104-year history. QT changes everything for world financial markets levitated by years of quantitative easing. The advent of the QT era has enormous implications for stock markets and gold that all investors need to understand.
This week’s FOMC decision to birth QT in early October certainly wasn’t a surprise. To the Fed’s credit, this unprecedented paradigm shift had been well-telegraphed. Back at its mid-June meeting, the FOMC warned “The Committee currently expects to begin implementing a balance sheet normalization program this year”. Its usual FOMC statement was accompanied by an addendum explaining how QT would likely unfold.
That mid-June trial balloon didn’t tank stock markets, so this week the FOMC decided to implement it with no changes. The FOMC’s new statement from Wednesday declared, “In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.” And thus the long-feared QT era is now upon us.
The Fed is well aware of how extraordinarily risky quantitative tightening is for QE-inflated stock markets, so it is starting slow. QT is necessary to unwind the vast quantities of bonds purchased since late 2008 via QE. Back in October 2008, the US stock markets experienced their first panic in 101 years. Ironically it was that earlier 1907 panic that led to the Federal Reserve’s creation in 1913 to help prevent future panics.
Technically a stock panic is a 20%+ stock-market plunge within two weeks. The flagship S&P 500 stock index plummeted 25.9% in just 10 trading days leading into early October 2008, which was certainly a panic-grade plunge! The extreme fear generated by that rare anomaly led the Fed itself to panic, fearing a new depression driven by the wealth effect. When stocks plummet, people get scared and slash their spending.
That’s a big problem for the US economy over 2/3rds driven by consumer spending, and could become self-reinforcing and snowball. The more stocks plunge, the more fearful people become for their own financial futures. They extrapolate the stock carnage continuing indefinitely and pull in their horns. The less they spend, the more corporate profits fall. So corporations lay off people exacerbating the slowdown.
The Fed slashed its benchmark federal-funds interest rate like mad, hammering it to zero in December 2008. That totally exhausted the conventional monetary policy used to boost the economy, rate cuts. So the Fed moved into dangerous new territory of debt monetization. It conjured new money out of thin air to buy bonds, injecting that new cash into the real economy. That was euphemistically called quantitative easing.
The Fed vehemently insisted it wasn’t monetizing bonds because QE would only be a temporary crisis measure. That proved one of the biggest central-bank lies ever, which is saying a lot. When the Fed buys bonds, they accumulate on its balance sheet. Over the next 6.7 years, that rocketed a staggering 427% higher from $849b before the stock panic to a $4474b peak in February 2015! That was $3625b of QE.
While the new QE bond buying formally ended in October 2014 when the Fed fully tapered QE3, that $3.6t of monetized bonds remained on the Fed’s balance sheet. As of the latest-available data from last week, the Fed’s BS was still $4417b. That means 98.4% of all the Fed’s entire colossal QE binge from late 2008 to late 2014 remains intact! That vast deluge of new money created remains out in the economy.
Don’t let the complacent stock-market reaction this week fool you, quantitative tightening is a huge deal. It’s the biggest market game-changer by far since QE’s dawn! Starting to reverse QE via QT radically alters market dynamics going forward. Like a freight train just starting to move, it doesn’t look scary to traders yet. But once that QT train gets barreling at full speed, it’s going to be a havoc-wreaking juggernaut.
QT will start small in the imminent Q4’17, with the Fed allowing $10b per month of maturing bonds to roll off its books. The reason the Fed’s QE-bloated balance sheet has remained so large is the Fed is reinvesting proceeds from maturing bonds into new bonds to keep that QE-conjured cash deployed in the real economy. QT will slowly taper that reinvestment, effectively destroying some of the QE-injected money.
These monthly bond rolloffs will start at $6b in Treasuries and $4b in mortgage-backed securities. Then the Fed will raise those monthly caps by these same amounts once a quarter for a year. Thus over the next year, QT’s pace will gradually mount to its full-steam speed of $30b and $20b of monthly rolloffs in Treasuries and MBS bonds. The FOMC just unleashed a QT juggernaut that’s going to run at $50b per month!
When this idea was initially floated back in mid-June, it was far more aggressive than anyone thought the Yellen Fed would ever risk. $50b per month yields a jaw-dropping quantitative-tightening pace of $600b per year! These complacent stock markets’ beliefs that such massive monetary destruction won’t affect them materially is ludicrously foolish. QT will naturally unwind and reverse the market impact of QE
This hyper-easy Fed is only hiking interest rates and undertaking QT for one critical reason. It knows the next financial-market crisis is inevitable at some point in the future, so it wants to reload rate-cutting and bond-buying ammunition to be ready for it. The higher the Fed can raise its federal-funds rate, and the lower it can shrink its bloated balance sheet, the more easing firepower it will have available in the future.
But QT has never before been attempted and is extremely risky for these QE-levitated stock markets. So the Fed is attempting to thread the needle between preparing for the next market crisis and triggering it. Yellen and top Fed officials have been crystal-clear that they have no intention of fully unwinding all the QE since late 2008. Wall Street expectations are running for a half unwind of the $3.6t, or $1.8t of total QT.
At the full-speed $600b-per-year QT pace coming in late 2018, that would take 3 years to execute. The coming-year ramp-up will make it take longer. So these markets are likely in for fierce QT headwinds for several years or so. At this week’s post-FOMC-decision press conference, Janet Yellen took great pains to explain the FOMC has no intentions of altering this QT-pacing plan unless there is some market calamity.
Yellen was also more certain than I’ve ever heard her on any policy decisions that this terminal $50b-per-month QT won’t need to be adjusted. With QT now officially started, the FOMC is fully committed. If it decides to slow QT at some future meeting in response to a stock selloff, it risks sending a big signal of no confidence in the economy and exacerbating that very selloff! Like a freight train, QT is hard to stop.
With stock markets at all-time record highs this week, QT’s advent seems like no big deal to euphoric stock traders. They are dreadfully wrong. CNBC’s inimitable Rick Santelli had a great analogy of this. Just hearing a hurricane is coming is radically different than actually living through one. QT isn’t feared because it isn’t here and hasn’t affected markets yet. But once it arrives and does, psychology will really change.
Make no mistake, quantitative tightening is extremely bearish for these QE-inflated stock markets. Back in late July I argued this bearish case in depth. QT is every bit as bearish for stocks as QE was bullish! This first chart updated from that earlier essay shows why. This is the scariest and most-damning chart in all the stock markets. It simply superimposes that S&P 500 benchmark stock index over the Fed’s balance sheet.
Between March 2009 and this week’s Fed Day, the S&P 500 has powered an epic 270.8% higher in 8.5 years! That makes it the third-largest and second-longest stock bull in US history. Why did that happen? The underlying US economy sure hasn’t been great, plodding along at 2%ish growth ever since the stock panic. That sluggish economic growth has constrained corporate-earnings growth too, it’s been modest at best.
Stocks are exceedingly expensive too, with their highest valuations ever witnessed outside of the extreme bull-market toppings in 1929 and 2000. The elite S&P 500 component companies exited August with an average trailing-twelve-month price-to-earnings ratio of 28.1x! That’s literally in formal bubble territory at 28x, which is double the 14x century-and-a-quarter fair value. Cheap stocks didn’t drive most of this bull.
And if this bull’s gargantuan gains weren’t the product of normal bull-market fundamentals, that leaves quantitative easing. A large fraction of that $3.6t of money conjured out of thin air by the Fed to inject into the economy found its way into the US stock markets. Note above how closely this entire stock bull mirrored the growth in the Fed’s total balance sheet. The blue and orange lines above are closely intertwined.
Those vast QE money injections levitated stock markets through two simple mechanisms. The massive and wildly-unprecedented Fed bond buying forced interest rates to extreme artificial lows. That bullied traditional bond investors seeking income from yields into far-riskier dividend-paying stocks. Super-low interest rates also served as a rationalization for historically-expensive P/E ratios rampant across the stock markets.
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 naked 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 that 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.
QE’s dominating influence on stock prices is unassailable. The S&P 500 surged in its early bull years until QE1 ended in mid-2010, when it suffered its first major correction. The Fed panicked again, fearing another plunge. So it birthed and soon expanded QE2 in late 2010. Again the stock markets surged on a trajectory perfectly paralleling the Fed’s balance-sheet growth. But stocks plunged when QE2 ended in mid-2011.
The S&P 500 fell 19.4% over the next 5.2 months, a major correction that neared bear-market territory. The Fed again feared a cascading negative wealth effect, so it launched Operation Twist in late 2011 to turn stock markets around. That converted short-term Treasuries to long-term Treasuries, forcing long rates even lower. As the stock markets started topping again in late 2012, the Fed went all out with QE3.
QE3 was radically different from QE1 and QE2 in that it was totally open-ended. Unlike its predecessors, QE3 had no predetermined size or duration! So stock traders couldn’t anticipate when QE3 would end or how big it would get. Stock markets surged on QE3’s announcement and subsequent expansion a few months later. Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.
Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory. Traders realized that the Fed was effectively backstopping the stock markets! So greed flourished unchecked by corrections.
This stock bull went from normal between 2009 to 2012 to literally central-bank conjured from 2013 on. The Fed’s QE3-expansion promises so enthralled traders that the S&P 500 went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever! With the Fed jawboning negating healthy sentiment-rebalancing corrections, psychology grew ever more greedy and complacent.
QE3 was finally wound down in late 2014, leading to this Fed-conjured stock bull stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would have happened! Without more QE to keep inflating stocks, the S&P 500 ground sideways and started topping. Corrections resumed in mid-2015 and early 2016 without the promise of more Fed QE to avert them.
In mid-2016 the stock markets were able to break out to new highs, but only because the UK’s surprise pro-Brexit vote fueled hopes of more global central-bank easing. The subsequent extreme Trumphoria rally since the election was an incredible anomaly driven by euphoric hopes for big tax cuts soon from the newly-Republican-controlled government. But Republican infighting is making that look increasingly unlikely.
The critical takeaway of the entire QE era since late 2008 is that stock-market action closely mirrored whatever the Fed was doing. Ex-Trumphoria, all this bull’s massive stock-market gains happened when the Fed was actively injecting trillions of dollars of QE. When the Fed paused its balance-sheet growth, the stock markets either corrected hard or stalled out. These stock markets are extraordinarily QE-dependent.
The Fed’s balance sheet has never materially shrunk since QE was born out of that 2008 stock panic. Now quantitative tightening will start ramping up in just a couple weeks for the first time ever. If QE is responsible for much of this stock bull, and certainly all of the extreme levitation from 2013 to 2015 due to the open-ended QE3, can QT possibly be benign? No freaking way friends! Unwinding QE is this bull’s death knell.
QE was like monetary steroids for stocks, artificially ballooning this bull market to monstrous proportions. Letting bonds run off the Fed’s balance sheet instead of reinvesting effectively destroys that QE-spawned money. QE made this bull the grotesque beast it is, so QT is going to hammer a stake right through its heart. This unprecedented QT is even more dangerous given today’s bubble valuations and rampant euphoria.
Investors and speculators alike should be terrified of $600b per year of quantitative tightening! The way to play it is to pare down overweight stock positions and build cash to prepare for the long-overdue Fed-delayed bear market. Speculators can also buy puts in the leading SPY SPDR S&P 500 ETF. Investors can go long gold via its own flagship GLD SPDR Gold Shares ETF, which tends to move counter to stock markets.
Gold was hit fairly hard after this week’s FOMC decision announcing QT, which makes it look like QT is bearish for gold. Nothing could be farther from the truth. Gold’s post-Fed selloff had nothing at all to do with QT! At every other FOMC meeting, the Fed also releases a summary of top Fed officials’ outlooks for future federal-funds-rate levels. This so-called dot plot was widely expected to be more dovish than June’s.
Yellen herself had given speeches in the quarter since that implied this Fed-rate-hike cycle was closer to its end than beginning. She had said the neutral federal-funds rate was lower than in the past, so gold-futures speculators expected this week’s dot plot to be revised lower. It wasn’t, coming in unchanged from June’s with 3/4ths of FOMC members still expecting another rate hike at the FOMC’s mid-December meeting.
This dot-plot hawkish surprise totally unrelated to QT led to big US-dollar buying. Futures-implied rate-hike odds in December surged from 58% the day before to 73% in the wake of the FOMC’s decision. So gold-futures speculators aggressively dumped contracts, forcing gold lower. That reaction is irrational, as gold has surged dramatically on average in past Fed-rate-hike cycles! QT didn’t play into this week’s gold selloff.
This last chart superimposes gold over that same Fed balance sheet of the QE era. Gold skyrocketed during QE1 and QE2, which makes sense since debt monetizations are pure inflation. But once the open-ended QE3 started miraculously levitating stock markets in early 2013, investors abandoned gold to chase those Fed-conjured stock-market gains. That blasted gold into a massive record-setting bear market.
In a normal world, quantitative easing would always be bullish for gold as more money is injected into the economy. Gold’s monetary value largely derives from the fact its supply grows slowly, under 1% a year. That’s far slower than money supplies grow normally, let alone during QE inflation. Gold’s price rallies as relatively more money is available to compete for relatively less physical gold. QE3 broke that historical relationship.
With the Fed hellbent on ensuring the US stock markets did nothing but rally indefinitely, investors felt no need for prudently diversifying their portfolios with alternative investments. Gold is the anti-stock trade, it tends to move counter to stock markets. So why bother with gold when QE3 was magically levitating the stock markets from 2013 to 2015? That QE3-stock-levitation-driven gold bear finally bottomed in late 2015.
Today’s gold bull was born the very next day after the Fed’s first rate hike in 9.5 years in mid-December 2015. If Fed rate hikes are as bearish for gold as futures speculators assume, why has gold’s 23.7% bull as of this week exceeded the S&P 500’s 22.8% gain over that same span? Not even the Trumphoria rally has enabled stock markets to catch up with gold’s young bull! Fed rate hikes are actually bullish for gold.
The reason is hiking cycles weigh on stock markets, which gets investors interested in owning counter-moving gold to re-diversity their portfolios. That’s also why this new QT era is actually super-bullish for gold despite the coming monetary destruction. As QT gradually crushes these fake QE-inflated stock markets in coming years, gold investment demand is going to soar again. We’ll see a reversal of 2013’s action.
That year alone gold plunged a colossal 27.9% on the extreme 29.6% S&P 500 rally driven by $1107b of fresh quantitative easing from the massive new QE3 campaign! That 2013 gold catastrophe courtesy of the Fed bred the bearish psychology that’s plagued this leading alternative asset ever since. At QT’s $600b planned annual pace, it will take almost a couple years to unwind that epic $1.1t QE seen in 2013 alone.
Interestingly the Wall-Street-expected $1.8t of total QT coming would take the Fed’s balance sheet back down to $2.6t. That’s back to mid-2011 levels, below the $2.8t in late 2012 when QE3 was announced. Gold averaged $1573 per ounce in 2011, and it ought to head much higher if QT indeed spawns the next stock bear. That’s the core bullish-gold thesis of QT, that falling stock prices far outweigh monetary destruction.
Stock bears are normal and necessary to bleed off excessive valuations, but they are devastating to the unprepared. The last two ending in October 2002 and March 2009 ultimately hammered the S&P 500 49.1% and 56.8% lower over 2.6 and 1.4 years! If these lofty QE-levitated stock markets suffer another typical 50% bear during QT, huge gold investment demand will almost certainly catapult it to new record highs.
These QE-inflated stock markets are doomed under QT, there’s no doubt. The Fed giveth and the Fed taketh away. Stock bears gradually unfold over a couple years or so, slowly boiling the bullish frogs. So without a panic-type plunge, the tightening Fed is going to be hard-pressed to throttle back QT without igniting a crisis of confidence. As QT slowly strangles this monstrous stock bull, gold will really return to vogue.
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The bottom line is the coming quantitative tightening is incredibly bearish for these stock markets that have been artificially levitated by quantitative easing. QT has never before been attempted, let alone in artificial QE-inflated stock markets trading at bubble valuations and drenched in euphoria. All the stock-bullish tailwinds from years of QE will reverse into fierce headwinds under QT. It truly changes everything.
The main beneficiary of stock-market weakness is gold, as the leading alternative investment that tends to move counter to stock markets. The coming QT-driven overdue stock bear will fuel a big renaissance in gold investment to diversify stock-heavy portfolios. And the Fed can’t risk slowing or stopping QT now that it’s officially triggered. The resulting crisis of confidence would likely exacerbate a major stock-market selloff.
By Adam Hamilton
