How Markets May React To Fed’s QT Program

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Introduction

This article looks at the potential market impacts of ending the fourth and latest Quantitative Easing (QE) program by the Federal Reserve. Special emphasis is on the new Quantitative Tightening (QT) period unveiled by the Fed on May 4th. We have four prior QE programs to review for analysis. In addition, several tapering periods and a 2018 Quantitative Tightening (QT) period will also be closely reviewed for market impacts.

Executive Summary

There have been four QE programs conducted by the Federal Reserve since the Global Financial Crisis through March 9th, 2022. We are currently in the after QE 4 period about to begin the first QT ramp scheduled for June 2022. The current “After QE4” time period has been particularly negative and is included in the analysis that follows. The following average returns have been observed in each of the different periods:

  • S&P 500 (SPY) returns during all 4 QE periods totaled +118.2% averaging +1.55% per month.
  • S&P 500 returns after the conclusion of the 3 prior QE periods total +52.14% averaging +0.58% per month.
  • S&P 500 returns during the 2018 QT ramp up period totaled -6.24% averaging -0.52% per month.
  • S&P 500 returns during the 2019 QT removal period totaled +17.82% averaging +2.22% per month.
  • In the current period after QE 4 ended March 9th the S&P 500 is down -3.61% in less than 3 months.

SPY chart with Fed QE / QT programs

VMBreakouts.com

As the chart above shows, the S&P 500 could fall another -15% and still be in the positive channel from 2009. Much of this above trend price action stems from record stimulus and extremely accommodative monetary policy after the Covid pandemic. We can estimate that the Federal Reserve’s quantitative easing has provided enormous financial benefits that exceed both the periods without quantitative easing as well as returns in the quantitative tightening period. These strong results confirm that Fed intervention in the markets since the Global Financial Crisis has provided significant benefit and shows why they have returned to this monetary policy four times in the past 13 years. It seems likely the Fed will use QE again in future economic concerns.

QE chart

Visual Capitalist

Many other factors have certainly contributed to market performance since 2008, but for simplicity of analysis this review paints a broad stroke on Fed intervention and does not consider all possible factors that have impacted the markets during these periods.

Analysis

There have been four QE programs conducted by the Federal Reserve from the Global Financial Crisis in 2008 through March 2022. The Fed operates QE by purchasing treasuries, mortgage backed securities and agency debt. By far the largest QE program was the most recent from March 2020 consisting of nearly $6 trillion in MBS and treasury purchases.

Federal Reserve Programs

Zerohedge

In this updated article I have separated the QT period parts for a more detailed analysis and added a rate hike comparison.

Fed Fund Rate Hikes

In the last rate hike regime the Federal Reserve hiked rates nine consecutive times from 2015 before halting at the market lows on December 19th, 2018. So far in 2022 the Fed has conducted one 25 bps hike and one 50 bps hike in the past two FOMC meetings. The 50 bps point move is the largest in 22 years. Every prior rate hike regime since the 1980s has ended with lower highs than the initial target and with lower rates than the previous hiking program. Some attribute this pattern of declining rate peaks to the rising cost of carrying more debt and the inability of any Federal Reserve hiking regime to sustain higher rates that result in the government paying higher debt interest payments. At least one analyst believes the Fed cannot move the Fed funds rate above 1% without having to move back into an easing cycle.

Federal Reserve rate hikes

Refinitiv

The market expects at least five more rate hikes in 2022 following the Fed proposal with the next two rate hikes likely to 50 bps each. This is the most aggressive rate hike schedule proposed in decades, but it remains to be seen if conditions can sustain so many hikes so quickly.

The chart below shows each of the different easing, tightening, and intervening periods along with the 10 year treasury price, Fed funds rate, and the S&P 500 index. In the period from December 2015 to 2018 the Fed was also increasing the Fed funds rate in nine additional tightening measures. The Fed fund rate has now been increased by 75 bps for the first time since 2016 and may contribute additional impact on the markets.

How the Stock Market Reacts to Recent Quantitative Tightening and Balance Sheet Run-off | Investment Moats

Bloomberg Finance

The correlation between rate hikes and S&P 500 returns indicates that it is not the number of hikes that impacts the market as it is the level of interest rates that suddenly trigger outflows from the market to other securities like bonds. With five proposed rate hikes in the remaining 9 months of the year a similar adverse market reaction could be triggered by the end of the year. However, I submit the larger concern will be the liquidity drain from the Federal Reserve’s aggressive quantitative tightening schedule.

Federal Reserve Program Analysis

Next we will look at the S&P 500 performance during each these periods as well as the time in between each of these accommodative periods of easing. The purpose is to provide a general forecast of what we might expect now that QE4 has ended and what may occur when the next quantitative tightening period begins in June. Once again I have added more events on the schedule as more information has been obtained.

Federal Reserve Program S&P 500 Return Duration/Mo Avg/Mo
QE1 (Nov 2008 – Mar 2010) +20.72% 17 months +1.22%
After QE1 +6.89% 9 months +0.76%
QE2 (Nov 2010 – Jun 2011) +9.21% 9 months +1.02%
After QE2 +7.10% 15 months +0.47%
QE3 (Sep 2012 – Oct 2014) +43.47% 26 months +1.67%
After QE3 +43.17% 39 months +1.10%
QT ramp 1 (Jan 2018 – Sep 2018) +8.99% $30B/mo 9 months +0.99%
QT ramp 2 (Oct 2018 – Dec 2018) -13.97% $50B/mo 3 months -4.65%
QT removal (Jan 2019 – Aug 2019) +17.82% 8 months +2.22%
QE4 (Mar 2020 – Mar 2022) +44.81% 24 months +1.87%
After QE4 -3.61% ~ 3 months -1.20%
QT ramp 1 (Jun 2022 – Aug 2022) $47.5 Billion/month 3 months
QT ramp 2 (Sep 2022 – ?) $95 Billion/month ? months

  • The largest average monthly returns for the S&P 500 occurred during accommodative Fed programs of QE and during the QT removal period.
  • The QT removal period saw the largest interest rate reductions by the Fed and also much less tightening each month until no liquidity was being drained by the Fed.
  • QE4 was by far the largest easing program and corresponds with the highest monthly S&P 500 average returns.
  • QE1 and QE3 were of near equal levels of Fed intervention and both larger than QE2 and both also reflected higher S&P 500 returns than those during QE2.
  • In all prior cases after each QE program ended the S&P 500 returns remained positive until this year after QE 4. The average returns have become substantially lower than during all the active QE periods.

We are currently in the period After QE 4 and ahead of the June QT ramp 1 up to $47.5 billion per month liquidity drain from the Fed. What should we expect now that we know the Federal Reserve’s proposed QT schedule?

Forecasting the Market Impact

We are two months into the period after the largest QE program since 2008 has ended and only a few weeks away from the largest proposed QT schedule in US history. What should we expect now?

  1. As expected the S&P 500 monthly average returns have become much less positive since the end of QE 4 on March 9th with the S&P 500 declining -3.6% to date.
  2. In the prior QT ramp in 2018 volatility was extreme and I tracked and traded leveraged funds very aggressively through the negative Momentum Gauge signals to the end of December.
  3. We have had only one quantitative tightening period in 2018 to evaluate and it corresponded to negative S&P 500 returns and very high market volatility.

In this update I will be looking at the QT schedule comparison with 2018 to try to anticipate how the reduction in market liquidity may impact markets in 2022. The prior QT schedule of Fed tightening in 2018 correlated strongly with the CBOE VIX volatility index as I wrote about frequently in those years. Members can review Section 10 of the Members’ Library for many more articles and charts.

VIX Trading Patterns To Watch Closely Through The Fed’s Asset Unwind Into 2019 | Seeking Alpha Marketplace

QT ramp 1 (Jan 2018 – Sep 2018) +8.99% $30B/mo 9 months +0.99%
QT ramp 2 (Oct 2018 – Dec 2018) -13.97% $50B/mo 3 months -4.65%
QT removal (Jan 2019 – Aug 2019) +17.82% 8 months +2.22%
QE4 (Mar 2020 – Mar 2022) +44.81% 24 months +1.87%
QT ramp 1 (Jun 2022 – Aug 2022) $47.5 Billion/month 3 months
QT ramp 2 (Sep 2022 – ?) $95 Billion/month ? months

June through the end of the year may reveal some record volatility as liquidity drains at rates never seen before.

CBOE VIX volatility index 2018

VIX above 32 back in 2018 was considered “Volmageddon” and it knocked out volatility funds into delisting. Moving from 12 to 20 on the volatility index was a very big deal in 2018. The VIX is based on derivatives of the S&P 500 and correlates strongly with S&P 500 price movement.

Chart of QT on VIX

VMBreakouts.com

S&P 500 volatility chart on FinViz

VMBreakouts.com

Below you can see the corresponding VIX volatility chart with the 2018 S&P 500 performance above. What happens in 2022 when QT begins in June and the VIX is already above 30?

FinViz VIX chart 2018

VMBreakouts.com

Just as we are seeing a major breakdown in the FANG Index stocks MicroSectors FANG+ Index 3X Leveraged ETN (FNGU) in 2022 back to the lowest levels since early 2020, there was a similar breakdown pattern in FNGU in 2018.

FANG index breakdown chart for 2022

FNGU chart

FinViz

FANG index breakdown chart for 2018

In December 2018 the FNGU price finally broke out of the long negative bearish stair step channel as the Fed announced the end of the QT cycle and began cutting interest rates again. I suspect this will be the indicator for 2022 when the FANG mega caps finally breakout of their negative channels since the November 2021 Momentum Gauge topping signal.

FinViz FNGU 2018 chart

VMBreakouts.com

The Momentum GaugesĀ® provided the topping signals in 2018 and continue to show strong negative conditions in 21 out of the last 24 weeks into 2022.

Momentum Gauge topping signals

FinViz

Related to this period of tightening in 2018, I conducted a study comparing the VIX volatility to the size of the reduction in treasury securities held by the Federal Reserve. The analysis detailed in articles linked above basically illustrates that the more the Fed reduced asset holdings, the higher the market volatility became:

Analysis of VIX and Treasury changes

VMBreakouts.com

Currently the Fed holds a large percentage of the treasury market now estimated at over 25% into 2022. This high balance shown below from record amounts of QE4 purchases increases the risk that future tightening events may be longer and more severe than we experienced in 2018.

Fed treasury assets and QE

refinitiv

Conclusion

The next most important phase for the markets will be the June start of the QT asset reduction program. There are no shortage of major economic factors that will continue to impact the market performance for 2022 and beyond. Inflation measures are at the highest levels in 40 years. The US GDP missed estimates in Q1 and moved into contraction even as GDP outlook is being revised lower and economic conditions are strained.

Many factors may affect the analysis shared here today. The purpose of this article is to provide some guidance about what the end of the largest QE program in U.S. history and the start of the largest QT program may mean to investors. It is likely that market returns will decline in the coming months with the proposed programs taking their full effect. The information above is intended to provide readers with additional insight into the potential market reactions in the coming year.

Thanks for reading and all the best in your investing decisions!

JD Henning, PhD, MBA, CFE, CAMS

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