As quantitative tightening moves to full speed, I thought it would be a good idea to update some of the charts from the popular "7 Charts on Quantitative Tightening" article.
The commencement of quantitative tightening (or, officially, balance sheet normalization), marked an important milestone in the history of the grand monetary policy experiment that kicked off in the wake of the global financial crisis. There has been intense debate about the efficacy and equity of QE and I'm sure that in time there will be equally strong debate and discussion about the as yet not fully known impact of QT. At the very minimum it is a key macro factor and should not be ignored, forgotten, or underappreciated for the risk-conscious investor. So this set of charts should provide a useful reference as we move further along the road in this grand experiment.
The key takeaways on quantitative tightening (or QT) are:
- We're now at the maximum planned pace of $50B per month (vs $85B at the height of QE3).
- Already we've arguably seen the impact of QT on the bond market.
- We're beginning to see the impact of QT on the US dollar, and this could be just the start.
- Similarly we're starting to see the impact of the turning of the tides in global monetary policy on global equities, as central banks move from suppressors to sources of volatility.
1. Best Laid Plans: As noted in the November Implementation Note, quantitative tightening or QT is now running at maximum pace of US$50B per month (contrast that to a pace of Quantitative Easing or QE of $85B during QE3). The initial plans for balance sheet normalization where outlined in mid-2017 and at this point no one knows, not us nor the Fed, how long the pace of $50B a month will continue, but the chart below shows a projection based on full use of the cap each month.
2. The Quantum of Quantitative Tightening: Using another angle, this chart shows the total amount of quantitative tightening or balance sheet reduction that has been completed so far. As of the time of writing, the Fed's holdings of Treasuries have been reduced by almost $200B, and total assets have been reduced by over $300B now. So while the flow (recall, $50B max QT vs $85B max QE back in QE3 days) is already definitely material, the stock is also getting to a point where it's not easy to ignore or dismiss as an important issue for markets.
3. QT vs Bond Yields: Looking at the path of QT vs bond yields, we can see a loose link, at the least it's fair to say that the beginning of QT was a catalyst to higher yields (bond yields shown inverted in the chart). Strictly from a flows and supply/demand standpoint QT should be a bearish force for bonds - you can get a little nuanced in that argument however if you take the point of view that QT is ultimately a tightening measure and ultimately will slow the economy and hence the growth/inflation outlook and hence act as a headwind to higher yields. But for now it's a force for higher yields.
4. QT vs the S&P 500: Same thing but looking at it vs the stock market. Again, all else equal, QT is a monetary policy tightening measure and by itself this should be a headwind for stocks. Indeed, if you believe that QE was a tailwind for stocks it's just plain logic that QT should be a headwind, and as the stock and flow of QT have stepped up, I find myself going back to my assertion that central banks globally are moving to becoming a source of volatility rather than suppressor of volatility. And I think initial evidence does in part support this view.
5. QT and the US Dollar: Moving on to the US dollar, you can debate about the impact of monetary policy on bonds and stocks, but with exchange rates it's probably the most purest expression of monetary policy direction and decisions. To that end, again if you ignored everything else, in the short run QT should be a bullish force for the US dollar. Back to the old world, a lot of commentators were describing QE as part of a big currency war and a stealth attempt to beggar thy neighbor by driving currency devaluation - and hence using currencies as a key transmission mechanism for experimental monetary policy measures. Keep that logic, and QT is a force for currency appreciation. This is perhaps the most important potential impact of QT.
6. The Big 3 QE Central Banks: Looking globally, the tides have turned on the grand monetary policy experiment. While the Fed is doing QT, the ECB is in explicit taper mode, and the BOJ in stealth taper mode - and the chart shows the Big 3 QE central banks clearly all headed to the exits. This is uncharted territory for markets and portfolio managers, and the next chart shows just how direct and profound this change has been...
7. Shadow Policy Rates and the Great Experiment: One way in which we can assess the impact of changes in balance sheets is the use of "shadow policy rates" - i.e. the effective level of policy rates given the impact of QE. The chart below shows a composite of developed market monetary policy rates with and without the shadow rates - the QE-effective composite rate has moved up over 200bps since the low point, vs less than 100bps on a headline basis. So basically we can see in this chart that already there has been a substantial tightening of global policy rates based on the changes in actual rates along with the changes in balance sheets.
8. Shadow Rates vs Global Equities: This final chart maps this against global equities, and it starts to really put the increased volatility we've seen this year into context. Indeed, as central bank balance sheets normalize around the world and we move further from the path of rate cuts to rate hikes, this headwind to global equities will only intensify. Back to my previous point - if QE was a tailwind for stocks, then QT is a headwind. But in the end, maybe this is nothing new, but simply the logical progression through the business cycle, and if that's the case then it's just a matter of keeping on top of the right indicators and running a sensible asset allocation process.
