Blog Hero Image

Posted by Craig Basinger on May 30th, 2022

Don’t Fret QT, It Is the Announcement that Hurts

The U.S. Federal Reserve is about to commence quantitative tightening (QT). For those not all up to speed on quantitative maneuvers by central banks, QT and quantitative easing (QE) are two tools central banks have used extensively over the past decade or so. To simplify things, QE is when the central bank buys bonds to support the market/economy. Obviously, someone has to sell them these bonds, meaning that the seller then gets some cash in their pocket. Perhaps they buy another Treasury bond, or maybe an investment-grade bond. Once again, the new seller has cash in their jeans. And so it goes. This even trickles all the way down to equities. Essentially, QE injects liquidity into the financial markets, and financial markets really like liquidity.

All things being equal, more buyers of bonds would lift the price higher and thus move the yield lower. This is ideal for a central bank attempting to lift asset prices to provide stability and encourage economic activity. But things are never equal—more on this later.

The opposite of QE is QT. In this case, the central bank is selling their bonds or allowing them to expire. If selling, another investor needs to have the capital to buy said bond, so they may sell another asset to raise money. This is removing liquidity. Letting a bond mature has the same impact as chances are the government that issued the bond has to refinance and issue a replacement bond, which has to be purchased by someone.

Note to reader: yes, this is oversimplified. QE can be immunized, it can be used to buy other assets, etc. But don’t want to get too far into the weeds of the mechanics. QE injects liquidity and QT removes it.

So why are we talking “Q” today? Well, if you thought the amount of QE following the financial crisis was big, the QE following the pandemic has been epic. And this certainly contributed to inflating asset prices from bonds, to equities to real estate. And as we are on the cusp of starting QT, the opposite of this is liquidity injection. So will markets tumble and yields rise even more?

What does happen when the music stops

If everything else were static, QT would remove liquidity from the financial system. This would cause asset prices to fall, meaning equity and bonds prices would move lower (and bond yields higher). That is perfectly logical. But the markets are not static, and they actually are filled with a healthy portion of smart people. The start of QT is not news—it has been telegraphed and announced multiple times. Which means, dare we say, it’s priced in?

In fact, if you look at past rounds of QE, it was the announcement that moved markets and bond yields—often weeks or months before the actual commencement of bond purchases. And when those actual bond transactions started, the market had often priced in the pending Fed action and, in most cases, had overreacted (i.e., gone too far).

The following charts pack a lot of information. Each one has the 10-year Treasury yield and S&P 500 during various QE programs. For QE1, 2 & 3, there is a vertical line when the announcement was made, a line when the actual QE commenced, and a line when it ended.

To varying degrees, bond yields tended to react lower to the announcement and then rise when the bond buying actually started. In each case, bond yields moved higher during QE, the opposite of what one would expect. Meanwhile, the equity market loves QE and rises during these periods. The QT chart for 2017 shows a limited reaction in yields and the market. This is encouraging.

The Covid QE chart at the bottom is a bit more complicated. The S&P 500 clearly rose on QE and peaked around the announcement of a pending QT. Interesting. However, there was still bond buying occurring, just at a declining pace as QT is just about getting started now. Still, it does appear that the announcement carried the punch and perhaps the actual quantitative tightening won’t have much impact.


Investment Implications

We are obviously in uncharted waters from the perspective of monetary policy and influence in the market. And while we all love to draw neat conclusions, such as QE lifts markets and QT hurts markets, there are always other factors at work. Change in economic momentum, investor risk appetite, valuations…the list is long and ever changing. Markets are lower this year for a host of reasons from inflation, war, slowing economic growth, and clearly the QT announcement.

Hard conclusions in the investment world are hard to come by. That being said, based on historical market reactions to QE & QT, we would not be overly concerned about the onset of QT. It was the announcement months back that was the bigger deal. And it is possible the bond and equity market may have already overreacted.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

Get the latest market insights to your inbox each week.

Sources: Charts are sourced to Bloomberg L.P.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Craig Basinger, CFA

Craig Basinger is the Chief Market Strategist at Purpose Investments. With over 25 years of investment experience, Craig combines an educational foundation in economics & psychology with years of experience in both fundamental and quantitative research. A long-term student of the markets, Craig’s thoughts and insights can be seen in his Market Ethos publications and through his regular contributions on BNN.

Craig and his team bring a transparent and cost-efficient approach to investment management. The team provides asset allocation OCIO services and directly manages over $1 billion in assets. The team manages dividend mandates, quantitative risk reduction strategies and asset allocation services.