QT on the QT
As monetary policy has become increasingly important to financial markets, it is not surprising that discussions about rate increases have become fairly intense. Such discussions have taken on the character of barroom arguments over subjects like the best baseball player in history: Everyone has an opinion and will argue it with anybody in earshot.
What is far less discussed, however, is the program of quantitative tightening (QT). To be sure, the Fed has been fairly quiet itself on the subject, but the subject hasn't resonated strongly with the investment community either. This creates an opportunity of sorts. Because the low profile of QT belies its significant potential to cause harm, those who are familiar with the mechanism will have a leg up navigating the consequences.
A good place to start an investigation of QT is to better understand why it has been so understated. Part of the reason is due to the fact the Fed missed important inflation signals and continued QE for too long.
For instance, a year ago, at the end of the summer of 2021, the 10-year Treasury yielded just above 1.3%. Part of the reason the yield was so low was because there was a widespread belief inflation would be transitory. Part of the reason for the belief in transitory inflation was because that was the message the Fed regularly and loudly communicated. It was wrong.
Indeed, it was so wrong it prompted Gary Shilling to exclaim in a recent note, “The Federal Reserve’s forward guidance program has been a disaster, so much so that it has strained the central bank’s credibility.” He goes on to explain the main problem with forward guidance has been “that it depends on data that the Fed had a miserable record of forecasting.”
Shilling concludes with one biting criticism: “Not only has forward guidance been a failure, but it may have increased, not reduced, financial market volatility.” In other words, the Fed probably did more harm than good.
It is understandable then why the Fed would prefer to avoid drawing attention to its failures and shortcomings. QT amounts to a painful admission the Fed screwed up.
While it is true the pandemic and related public policy responses presented a huge challenge to forecasting, there were still signals that could be analyzed. One of the people who got the inflation call right last year was Greg Jensen of Bridgewater Associates.
“And so, when you look at market prices today, what do you see? It's much more like what you're seeing is what the market thinks the policymakers will do to achieve the outcomes that they want rather than reflecting what economic conditions it will be."
"That's why, why is it that the bond yield is where it is [about 1.3% at the end of July 2021]? Well, people think that's where the Fed wants it, and that the Fed can get what they want. And so that's the thing. Now, I think, even on that basis, the markets are going to prove to be wrong because I think the Fed is going to be forced to change their policy, and they're going to allow a higher bond yield because they'll be overwhelmed by the evidence."
Turns out he was right. The Fed was overwhelmed by the evidence.
Fast-forward to today and while the Fed is backing away from guidance per se, plenty of market participants seem content sticking with the narrative of rapidly normalizing inflation. To that point, Jensen believes today’s market expectation “reflect inflation falling quite dramatically towards The [sic] Fed's target over the next 18-24 months, [as well as expectations that this decline] will occur in a relatively stable economy." In short, much of the market is still following the Fed’s discredited forecasts.
These benign market expectations contradict what Jensen himself sees: "The reality that starts to set in will be that inflation is more stubborn, The Fed tightens longer, that the expected easing in the next 6-9 months doesn't materialize, and at the same time profits and economic growth are weaker than people expect is going to make this a tough road for all assets."
So, another reason why QT doesn’t receive more attention is because a large part of the investment community doesn’t believe it will be needed. QT is falling on a lot of deaf ears.
The Fed has more to account for than simply making a bad call on inflation, however; it actively stoked inflation by pursuing Quantitative Easing (QE) for far too long. This provides another reason why QT is being pursued so quietly. The Fed’s fingerprints are all over the crime scene of inflation. It would vastly prefer to wipe away the evidence (through QT) and quietly slip away than to face a public trial.
Unfortunately for the Fed, the stakes are even greater than this. The main purpose of any central bank is to manage money supply and by association to keep inflation in check. By building such a massive balance sheet through QE, however, the Fed will have to reverse a huge amount of that through QT in order to be able to implement QE effectively again in the future.
In other words, QE was more than just excessive. It significantly handicapped the Fed to contend with any future slowdowns. The big threat is to the Fed’s very existence; a hobbled central bank doesn’t have much reason for being.
In order to understand the monetary mechanics of QE, John Hussman provided a nice explanation in a piece he put out earlier this year. What QE really does is to dial up speculative fervor by making it painful to hold zero-yielding cash. He explains:
As long as investor psychology is not risk-averse (which we gauge using market internals), investors view zero-interest cash as an “inferior” asset rather than a desirable one. They seek riskier alternatives in the hope of avoiding “zero,” and seem to pay no attention to the valuation of these alternatives. This maddening psychological discomfort with “zero” is how the Fed has created what we view as the broadest and most extreme speculative financial bubble in history.
If you want to know how markets can get so crazy as to not only enable, but embrace, meme stock moonshots, special purpose acquisition companies (SPACs), and countless crypto frauds, among other speculative excesses, look no further than QE. While these particular manifestations are not targeted per se, the notion of making investors extremely uncomfortable holding cash, and therefore willing to chase just about any crazy idea to avoid doing so, actually is the objective.
Now, however, with the Fed actively trying to dampen inflation by reducing demand, there are two problems with QE. The first can be seen through the framework of the liquidity preference curve, which is the relationship between Treasury bill yields and the monetary base. Essentially, the more money there is, the greater the desire to find something, anything, that returns better than cash. Hussman explains:
"Increase the quantity of zero-interest hot potatoes as a share of GDP, and investors respond by chasing yield in other securities. Treasury bills are the closest substitutes, so their yields are affected most reliably. Once base money hit the unprecedented level of 16% of GDP back in 2011, not a dollar more was actually needed in order to hold short-term interest rates at zero."
Beyond a certain threshold of money investors prefer just about any alternative to cash. Given the monetary base was about 28% of GDP (as of publication in February), it is easy to see why investors are still not interested in cash.
This also explains why so much speculative energy remains despite eroding fundamentals: There is still way too much money sloshing around. "Put simply, quantitative easing is an exercise in amplifying yield-seeking speculation."
The co-existence of excessive money (and its attendant speculative energy) and the desire of the Fed to tame inflation not only make the Fed’s efforts inefficient; it is just not a good look. It means the Fed is working at cross purposes. It is trying to tame inflation by flooring the gas and slamming on the brakes at the same time.
In the meantime, the clock is ticking. If the Fed cannot drain at least a couple of trillion dollars out of the monetary base through QT before a slowdown hits, it will be left with substantially reduced power to stanch the slowdown. Again, it’s not surprising the Fed prefers to avoid advertising this major constraint.
Even when central banks are relatively independent, as the Fed is, they are still influenced by politics. In order to manage this tension, it behooves them to manage the narratives around their policies. This has certainly been the case since inflation picked up and the Biden administration made fighting inflation a priority.
On the Fed’s part, it has emphasized rate increases to fight inflation but has played down the role of QT. This position facilitates a narrative of being tough on inflation but not so tough on inflicting economic harm.
In the process, a strong dollar, resulting from a tougher monetary policy stance than other central banks, also mitigates the inflationary impact of rising commodity prices. Good for the Biden administration and good for the Fed.
Along the same lines, national security interests are also served by the same agenda. Russia’s invasion of Ukraine, China’s increasingly bellicose disposition, and Russia and China’s newly established partnership made evident a new front of conflict is crystallizing. It became clear early on the US dollar would be part of this in a form of financial warfare.
The maintenance of QT, and therefore of a strong dollar, accomplishes a couple of important things in this conflict. One is that it moderates the effect of supply shortages on inflation for Americans. As such, it provides something of a “shield”. People still get hurt, but not nearly as badly as people without such a shield.
A strong dollar also imposes disproportionate pressure on China by increasing the cost of commodities and tightening liquidity at a time when its own economy is slowing and it is trying to restructure excessive debt.
Finally, it is possible to think even bigger along the lines of national interests. From the beginning in World War II, the Bretton Woods system was flawed and unsustainable. Through many crises since, opportunities were presented to redesign the system, but there was insufficient mutual interest to engage in difficult negotiations.
Now, it appears the US is maneuvering into a position from which it can compel others to the negotiating table – and at a time when it can negotiate from a position of strength. This is a terrific position to be in but will be forfeited if the hand is overplayed by being too overt with financial tactics.
In conclusion, it is a worthwhile question to ask, "Why is QT being done on the QT?" The messaging around QE was loud and clear and persistent. Why not the same for QT?
The simplest answer is also the best in this case. QT is being kept fairly quiet because that is what best serves the interests of most of the players involved. Investors who don’t believe the inflation argument have largely dismissed QT as unnecessary and irrelevant, but also miss the bigger purposes it serves. The Fed prefers to avoid as much public embarrassment as possible in an exercise of CYA. Politicians prefer a strong voice on inflation fighting and a quiet one on economic damage. National security interests prefer to quietly exert leverage over competitors like China while avoiding the headlines of fighting wars.
So, two important points can be taken away from this. One is QT needs to get done. It is not being kept quiet because it is unimportant. Quite the opposite in fact. It is being kept quiet so as to avoid the kind of attention that could energize opposition and threaten to scupper the program. The assumption made by many investors that QT will be reversed at the first sign of economic weakness is a dangerous one.
This leads to a second point. The major constituency that does not benefit from keeping QT quiet is investors. The mechanism of QT reduces the monetary base and that money must come from selling assets. As a result, investors who hang on the hope of a quick return to appreciating risk assets are going to be fully exposed to the wood chipper of persistent, grinding, deterioration of liquidity. Why would anyone advertise that?