Rising rates and recession fears in the US fuel bearishness. But a less recognised phenomenon is asserting itself in economic dynamics – quantitative tightening (QT). QT is the endgame of the largest monetary policy experiment in history, quantitative easing (QE). It is the flipside of the coin.
Since 2008, the world’s most important central banks have morphed from being lenders of last resort to buyers of first resort. The US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan have been on a multitrillion-dollar buying spree, mostly of bonds and mortgage-backed securities, to prop up the global economy. Investors allocated capital accordingly, based on where central banks were going.
As banks voraciously accumulated assets, balance sheets got swollen, expanding five times, from $5-trillion in 2008 to more than $26-trillion by 2022. The Fed and the ECB now own roughly 40% of their respective governments’ debt. The Bank of Japan owns even more.
Many economists have been critical of this untested and unproven gamble, citing complex side effects and structural distortions. Central banks, however, defended QE, citing potential positives. First, by injecting vast amounts of liquidity, they could ensure the credit crunch of 2008, when Lehman Brothers collapsed, did not happen again. Second, by keeping interest rates effectively capped, they could spur economic growth.
Economic historian Adam Tooze compares QE to “banging on a broken old black-and-white television. No one knows why it could work, or should work, but they do it anyway because it might work”. It might fix the patient but risks near-lethal side effects.
Central bankers were not unaware of the risks. They just said those outweighed the disastrous costs of doing nothing.
When Covid struck, central banks cranked up QE to unprecedented levels. In two years they bought almost $5-trillion of assets, fuelling a huge boom in all assets, from equities to bonds and crypto. Now, with inflation rampant, the banks are unwinding the operation, by not reinvesting maturing securities on balance sheets. They may start selling assets into the market, sucking up liquidity.
Morgan Stanley says the big four banks will cut balance sheets by $4-trillion in two years, much faster than first forecast. Simply put, no one – not even the banks – has any idea what will happen. But we can guess.
The immediate impact of QE was to create vast amounts of liquidity for transactions. This is ending, and fast. The last time the Fed tried to slow down QE it caused a liquidity crisis, in September 2019, as repo rates spiked. It is highly likely more such liquidity-freeze events lie ahead in previously calm and predictable markets.
Second, asset prices are likely to rerate. Central bank purchases crowded out other investors, pushing them to riskier securities or forcing them to speculate in the likes of crypto. This is now unwinding, and a process of pricing for risk is beginning.
Expect some assets, such as speculative equities, low-grade credit and crypto, to crash when the Fed backstop ends. The correction so far may turn out to be only the start of a more systemic and structural rerating. Investors would do well to wait it out in cash and top-quality, liquid assets.
Last, QT could lead to interest rates rising faster than expected, choking economic activity and compounding a recession.
This could create havoc for vulnerable emerging markets as investors rush back to the safe havens of the US dollar and other hard currencies.
The only thing we know for sure is that we are entering uncharted waters. We can only hope the effects of arcane monetary experiments will not be catastrophic. If they are, history will not judge this generation of central bankers kindly. DM168
This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R25.