Anyone paying attention to financial markets in recent months knew that the Federal Reserve’s management of the economy was perhaps the single most important question on the minds of investors.
The Fed, of course, has been raising interest rates, including four increases last year, which unnerved many investors. These days, though, the focus has shifted to what the central bank will do with another tool it previously used to stoke economic growth.
As part of its campaign to rescue the economy after the 2008 financial crisis, the Fed bought enormous quantities of bonds issued or guaranteed by the federal government. Now the question is how quickly, and by how much, it will shrink that pile.
On Wednesday, the Fed left rates unchanged and signaled that it could slow its bond sales if economic and financial conditions change. Investors cheered, with the S&P 500 (.SPX) rising about 1.5 percent. The index is up nearly 7 percent this year.
Once an area of interest for only the most intrepid of Fed watchers, the bond portfolio has started to overshadow more fundamental economic concerns, like China’s slowing economy and the government shutdown. Since last year, the Fed has been reducing its bond stockpile by up to $50 billion a month.
Investors increasingly point to the trend to explain the ugly performances of virtually every kind of investment in 2018. Even President Trump weighed in, tweeting in December that the Fed should “Stop with the 50 B’s.”
Players in the markets have bestowed the Fed’s bond-shedding policy with its very own nickname: quantitative tightening, or Q.T.
So what is quantitative tightening? How is it supposed to work? And how much of an impact is it having on markets? Read on.
Before there was Q.T., there was Q.E.
The first thing to know is that quantitative tightening is basically the slow unwinding of a series of policies put in place to counter the financial crisis.
A decade ago, that crisis nearly pushed the United States into a second Great Depression. Financial markets crashed. Unemployment surged. Economic growth collapsed.
By law, the Fed is supposed to fight unemployment. So, when recession rears its head, the central bank steps in, typically by cutting the short-term interest rates it controls. By the end of 2008, it had slashed them essentially to zero.
During normal times, short-term interest rates have a strong influence on how much it costs consumers and companies to borrow money. But during the financial crisis, the Fed’s rate cuts barely budged longer-term borrowing rates, which stayed stubbornly high. Investors were so spooked that they refused to put their money into anything other than super-safe, short-term government bonds.
The Fed needed to push longer-term interest rates down. With short-term rates at their lowest possible levels, the central bank went looking for new tools.
And that is how quantitative easing was born.
In early 2009, the Fed started buying immense quantities of bonds — trying to drive their prices up and their rates down. By 2014, the Fed was the proud owner of roughly $2.5 trillion worth of Treasury bonds and more than $1.5 trillion of government-backed mortgage bonds.
Did it work?
The Fed’s bond-buying didn’t immediately cure every economic ill brought on by the recession. The United States would limp through nearly a decade of sluggish growth, even as the Fed continued to devour bonds.
But the consensus among investors and policymakers is that all of the bond purchases helped push key borrowing rates — such as those for 30-year fixed-rate mortgages and for corporate bonds — to their lowest levels in a generation. That made loans at least a little more affordable and offered some support to the fragile economy.
In the stock and bond markets, the power of the Fed’s campaign was even more pronounced. By pumping trillions of dollars into the financial system, quantitative easing propped up the value of stocks, bonds and all sorts of other assets. Few in the markets think it a coincidence that the beginning of Q.E. was also the beginning of the longest bull market in history.
Now comes Q.T.
A decade later, the economy is in much better shape. Unemployment is at its lowest level in decades. Early data indicates that the economy last year grew at its fastest clip since 2005. Wages are even starting to rise.
To the central bank, those rosy economic signs meant it was time to start removing some of the scaffolding it had erected to support the crumbling economy. The Fed started raising interest rates in December 2015.
And it has also started to shrink its hoard of bonds. Last year, the Fed’s portfolio declined by more than $350 billion — the sharpest reduction since the crisis.
You may have also noticed that the financial markets were battered last year. Almost every type of investment seemed to suffer the same lackluster returns.
The S&P 500 was down 6.2 percent. High-quality corporate bonds sank 6.4 percent. United States Treasury bonds generated a paltry 0.9 percent return. A collapse in crude oil prices sent commodities down more than 15 percent. In fact, it was the first time in decades that virtually all major classes of investments suffered in sync, with none posting returns in excess of 5 percent.
The concern over Q.T. flared in December. As stock markets swung wildly, Jerome H. Powell, the Fed chairman, played down the chance that the central bank would change its approach to its steady bond reductions, which he described as being on “automatic pilot.” The stock market sank about 6 percent in the days after that statement.
The Fed’s shrinking bond portfolio isn’t entirely to blame for the carnage of 2018. Plenty of other things had investors worrying: a slowdown in global growth, weakening corporate profits, the trade war with China and the Fed’s rate increases.
Economists inside and outside the Fed say the impact last year should have been relatively small. After all, the gradual, recurring bond reductions were set in motion years ago, and should have been incorporated into prices in financial markets.
Nevertheless, investors welcomed the Fed’s message on Wednesday that it could change its plans to reduce its bond holdings. The central bank said in a news release that it was “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.” In a news conference, Mr. Powell also suggested that the decline of the Fed’s bond holdings could stop sooner and leave the Fed with a larger supply of bonds than previously thought.
“Any conversation about the balance sheet that does not use the word autopilot is good,” said Scott Wren, senior global equity strategist at the Wells Fargo Investment Institute.
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