Quantitative Tightening Should Drain Liquidity from Markets

The Federal Reserve aggressively started to buy assets on their balance sheet to stimulate asset markets (read the economy) in the wake of the Great Financial Crisis. The Federal reserve has always used US Treasury Bonds and Bills (repo market) to help control the money supply and interest rates. But the tendency in recent years is to use this additional tool during times of extreme duress to add liquidity to financial conditions. All may know the size of the balance sheet adds significant liquidity to asset markets and has the (un)intended(?) consequence of inflating market valuations by suppressing yields. The FOMC expects to shrink the balance sheet by several trillion in the coming year to add additional tightening to financial conditions. This will likely put pressure on yields and risk premiums.

Bond yields have started to move up in anticipation of higher for longer monetary policy and the bond supply pressure coming from both deficit financing and QT. The Congressional Budget Office (CBO) forecasts that public debt (not including the FOMC balance sheet) will be 46 trillion by 2033 at about 119% of GDP versus 26 trillion and 98% today. The percentage that interest costs impact the annual deficit is projected to continue to grow. To put it simply, the fiscal outlook is a significant headwind for economic growth. Frankly, Congress does not have the will to contain escalating costs despite the recent debt ceiling deal. The Federal Reserve balance sheet will likely need to continue to grow. That said, for the next 2 years before the ceiling is hit again, the goal will be QT and to reduce the balance sheet. This should help contain inflation, but could have a negative impact on asset prices. Time will tell as always, but it’s not the bullish tailwind for asset markets we have seen in recent years.

Do not believe for a minute that MSFT (6.8% of S&P 500) and AAPL (7.65% of S&P 500) should be trading at 30x plus multiples were it not for the abundant liquidity the central banks have created despite what Wall Street analysts would have you believe with their AI growth stories. They are both great companies, they are just hugely overvalued today.

Believe central banks when they say they are serious about fighting the inflation they helped create from inflating their balance sheets. Believe that less globalization, rebuilding supply chains and an aging workforce demographic will likely add inflationary pressures. Believe that aging and shrinking populations like Japan, China and Germany are deflationary. Believe the cost of debt financing will need to be monetized by larger central bank balance sheets.

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