It also has implications for the amounts of liquidity that have been sloshing around the US financial and global systems; implications that will be magnified if and when the European Central Bank and other central banks also follow through on their commitments to start their own QT programs.
On some estimates, more than $ US4 trillion of central bank buying could be withdrawn from the markets over the next 18 months.
The combination of the Fed’s rate hikes – it has foreshadowed another 75-basis-point increase next month, and the likelihood that a federal funds rate that was near zero at the start of this year could be 3.4 per cent at its end – and the start of QT means the price of credit will be rising even as its availability is falling.
If the Fed does not blink in the face of the steep selloffs in equity and bond markets, QT is as big a step into the unknown as QE was.
QE produced some unintended, or at least incidental, consequences. Not the least of them was a steady and ultimately near-complete erosion of any pricing for risk, which drove financial markets to extreme levels; levels that could only be justified by the absence of alternatives that could produce positive results and by a conviction that the Fed and its peers were providing a rising floor under all financial assets.
The outbreaks of inflation at 40-year highs in this post-pandemic environment of supply chain disruptions, labor shortages, continual COVID outbreaks in China and energy and food market shocks flowing from Russia’s invasion of Ukraine have pulled those rugs from under the markets.
The Fed can not ignore an inflation rate of 8.6 per cent, just as the European Central Bank can not ignore its rate of 8 per cent and rising or the Reserve Bank our rate of 5.1 per cent and rising. They are going to do whatever it takes to stamp out inflation, even if that results in another of those recessions we have to have, like the one Australia experienced in the early 1990s.
It has been the transformation of the Fed from dove to hawk, almost overnight, that has burst the bubbles it was largely responsible for creating in equity and debt markets. It’s also blown up the most speculative and risky asset class of them all, the market for crypto assets.
While the US sharemarket is down about 23 per cent since the start of the year and the tech-laden Nasdaq market is about 33 per cent off its peak late last year, the market capitalization of crypto assets has plunged from $ US3 trillion last October to about $ US880 billion today.
The crypto flagship, Bitcoin, traded at a record level of just under $ US70,000 last year and had a market cap of about $ US1.2 trillion. Over the weekend it was trading as low as $ US17,599 and, while it bounced back just above $ US20,000, the whole market for Bitcoin is now valued at about $ US390 billion. Bitcoin is proving to be the leading indicator of risk appetites in the market.
Just as QE – first rolled out in response to the 2008 financial crisis and then doubled down on in response to the pandemic – was unprecedented, so is QT.
While the realization that rates were going to march steadily higher this year – and keep rising until inflation is brought under control – explains why markets have tanked, there are already signs of reduced liquidity and a lack of depth in markets that is contributing to the size of falls.
In this opening phase of QT, that would almost certainly be more attributable to risk aversion by investors and lenders (there are reports of significant levels of margin lending and subsequent calls in the crypto market) than to the Fed’s balance sheet strategies.
It’s a sea change in attitudes to risk that is having the biggest impact on markets.
In the bond market, a fear of the value of bonds and the income they generate being overwhelmed by inflation has seen yields soar. At the start of the year, US 10-year bonds were yielding 1.5 per cent and two-year notes 0.73 per cent. They now yield 3.23 per cent and 3.2 per cent respectively.
In the junk bond market – the market for bonds issued by companies with poor credit ratings – the spread between the yields on the bonds and US Treasuries started the year at about 2.8 percentage points. Today it exceeds five percentage points.
Around the world rates are rising and credit conditions are tightening and – unless something unforeseeable occurs – rates will probably keep rising until at least well into next year and central bank liquidity will continue to be withdrawn for several more years.
For the over-leveraged governments, businesses and households that have been encouraged for nearly a decade and a half to gorge on cheap credit, that’s an intimidating prospect.
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