Stocks and Monetary Policy Institutions’ Shrinking Balance Sheets

Major monetary policy institutions like the Bank of England and ECB are shrinking their balance sheets.^[i] The US Federal Reserve’s (Fed’s) balance sheet has fallen to $7.6 trillion (£6.0 trillion), down -$1.4 trillion (-£1.1 trillion) since peaking in April 2022.^[ii] This process, known as quantitative tightening (QT), is the reverse of their quantitative easing (QE) bond buying.^[iii] In the Fed’s case, it lets assets it amassed (mainly Treasurys) mature, shrinking its balance sheet.^[iv] As the “tightening” in the name implies, many commentators we follow claim QT is, like rate hikes, restrictive monetary policy—and, like rate hikes, they say it is bearish. But recent history suggests otherwise, in our view.

America’s forays into QE started in November 2008.^[v] With short-term rates already cut to zero by then to combat the financial crisis, the Fed launched a programme aimed at stimulating credit creation by lowering long-term interest rates.^[vi] To do this, it hoovered up long-term Treasurys and mortgage-backed securities.^[vii] Buying bonds en masse boosts their prices, which move opposite their yields. And lower yields, according to many commentators we follow, encourage borrowing. They also allegedly push investors into potentially higher-returning-though-riskier assets like stocks. Whilst this first QE iteration ended in the late 2010s—with QT commencing in 2018—the Fed fired QE back up in March 2020, roughly doubling its balance sheet again in two years.^[viii]

But after US inflation jumped in late 2021 and early 2022, the Fed did a sharp 180, starting a cycle of rate hikes—and embarking on QT once more.^[ix] Officials first hinted at this in minutes released in April 2022.^[x] They officially followed through that June.^[xi] Many commentators we follow warned QT would cause markets to crater. To them, this would only add pressure to things like war, sanctions, ongoing inflation, supply chain issues and soaring energy prices months into what turned out to be 2022’s shallow bear market in US dollars.^[xii]

As Exhibit 1 shows, though, US stocks troughed in October 2022 whilst the Fed’s balance sheet kept shrinking and—after a brief (regional bank-run-related) jump last March—has steadily declined since. We think this resembles QT’s last 2018 – 2019 go ’round. At that time, commentators we follow also argued a QT-led stock derailment would ensue. And Q4 2018 did see a large correction.^[xiii] But the correction started well after QT began—and stocks had resumed rising well before the Fed’s balance-sheet shrinking stopped, as Exhibit 1 demonstrates. So although a significant pullback occurred during that round of QT, it seems like a coincidence to us—correlation without causation.

Exhibit 1: QT Doesn’t Deter Stocks

Source: FactSet, as of 29/2/2024. S&P 500 total return and Fed total assets, 23/2/2014 – 23/2/2024. Presented in US dollars. Currency fluctuations between the pound and dollar may result in higher or lower investment returns.

This brings us to the underlying reason why we think QT has failed to tank US stocks: It presumes low rates are needed for them to rise—but that isn’t so. In the high-and-rising rate 1970s, history shows no identifiable relationship between long rates and stocks.^[xiv] Rates rose three percentage points between October 1982 and June 1984—early in the 1982 – 1987 bull market, amongst other examples.^[xv] So we don’t think it should shock that US stocks have hit record levels lately whilst the fed funds rate stands at more than two-decade highs and 10-year Treasury yields hover at levels last seen 17 years ago.^[xvi]

Today, commentators we follow still talk about QT as though it is an issue, speculating its end, like rate hikes, is uber bullish. But they gloss over the part where QT was never bearish to begin with—echoing rate hikes, in our view. In any event, it may be the Fed doesn’t unwind every asset purchased and that QT’s end will come soon. But we find speculation over this is needless. To us, markets already showed you QT fear is false.