Quantitative easing (QE) is a tool central banks around the world use to lower interest rates and effectively increase the money supply by purchasing securities. Quantitative tightening (QT), on the other hand, is the opposite action whereby government securities are allowed to mature without reinvestment or sold outright to reduce the size of central bank balance sheets. The U.S. Federal Reserve (the Fed) was engaged in QE for much of the period following the 2008 Great Financial Crisis (GFC), and it recently began unwinding its balance sheet through QT.
It’s not just a domestic monetary policy action - many major central banks worked alongside each other, though not officially in a coordinated effort, to stimulate the global economy during the GFC and later into the 2010s. Following the Covid pandemic, however, unexpected inflation caused the Fed to reverse course by way of QT. That can have significant impacts on broader markets and your portfolio.
The History of Quantitative Easing
QE generally adds assets to a central bank’s balance sheet through the purchase of both short-term and long-term securities from financial institutions. Types of assets include Treasury securities, mortgage-backed assets (MBS), and even corporate bonds and equities in some cases. A common misconception is that QE is like printing money, but the reality is the financial sector takes on new reserves while the Fed owns more bonds with QE. The stimulative growth measure is enacted during periods of low GDP growth and near-zero inflation. The first round of the Fed’s QE was announced in November 2008. The second round came just two years later. “QE 3” in 2011 and 2012 focused on lowering rates on the long end of the Treasury curve.
To understand QE, it helps to revisit how financial markets behaved during and after the Great Recession. Deflation, and even a prolonged depression-like scenario, was on the table when bank after bank required bailouts or went bankrupt in 2008. Monetary policy stimulus was seen as a lever the Fed could pull to combat the dangers of deflation. While there were fiscal aid packages put through during that time by Congress, it was primarily monetary policy actions taken by the Federal Open Market Committee (FOMC) that did the heavy lifting.
Ben Bernanke, Fed Chair at the time, swiftly took the Fed Funds target rate from above 5% in 2007 to near zero percent by late 2008. Lowering short-term interest rates helps to increase liquidity across the economy thereby freeing up capital to flow and avoiding freezes in the credit market. It can also work to lower the risk of a deflationary spiral.
Following the GFC, the global economy was mired in a period of sluggish GDP growth and dangerously low inflation. Deflation is much more harmful than inflation since it can lead to a kind of death spiral for the economy in which demand just continues to sink as consumers anticipate lower and lower prices, thereby delaying purchases. Businesses, meanwhile, hold off on investments and hiring. Bernanke, a student and scholar of the Great Depression, recognized that risk. He continued QE during his tenure as the head of the U.S. central bank.
Global threats were also ongoing during the 2010s. The European Debt Crisis of 2011 and 2012 brought about renewed fears of yet another global financial crisis. Following the Fed’s tapering program in 2013 to reduce QE came a slowdown in growth from late 2014 through early 2016 as a result of collapsing commodity prices. More QE was needed from policymakers at the European Central Bank (ECB) and Bank of Japan (BoJ). Those monetary authorities even took interest rates negative in an effort to spur growth.
It was unknown what the effects of QE would be. For several years leading up to the Covid pandemic, QE seemed to have been a strong approach to combat the prior decade’s era of tepid real GDP growth. Even when the Fed sought to hike its policy rate and embark on QT in late 2018, financial markets panicked, and a fast 20% drop in stocks took place, forcing the new Fed Chair Jerome Powell to reverse course and reduce rates again.
While Powell hiked interest rates in 2018, the value of assets held at the Fed was near $4 trillion heading into 2019 and 2020. According to the Federal Reserve, the size of the central bank’s balance sheet declined slightly ahead of the pandemic. Covid, and a halt of all economic activity in March 2020, brought about the need to enact another big monetary stimulus initiative.
At the depths of the pandemic, the Fed re-engaged in QE by announcing a massive $500 billion asset-buying program with an additional $200 billion of MBS purchases. Those securities were bought all the way into early 2021 despite rising fears of inflation. At its peak, the Fed’s balance sheet swelled to just shy of $9 trillion in early 2022 as interest rates dropped, driving up the value of fixed-income securities.
Inflation indeed reared its ugly head as the U.S. emerged from the pandemic. The Fed was forced to quickly shift its focus from supporting growth through QE to squashing inflation by way of QT.
A New Regime: Quantitative Tightening
Quantitative tightening, the opposite of QE, describes monetary policy measures taken by central banks to normalize their balance sheets and effectively bring down the money supply. Letting bonds mature and selling off assets tends to reduce overall liquidity, though, technically, there is not a change in total financial assets across the financial system. QT has recently been instituted by the Fed to combat a 40-year high in the rate of inflation. The Fed and other central banks must keep a close watch on how financial markets react to QT as the threat of recession and even a global economic crisis can be significant. What’s more, there are concerns about who future buyers of Treasury securities will be now that the Fed is a seller, not a buyer, of government bonds.
QT is generally seen as a headwind for risky assets like stocks and a major problem for bonds. The fixed-income markets are highly dependent on interest rates – the higher rates go, the lower the value of bonds, all else equal. When the Fed and other central bankers stop buying bonds, and particularly when they are outright sellers, it can lead to a drastic shift in the supply-demand balance. Economics 101 teaches that when supply rises and demand falls, prices can drop fast. In the fixed-income market, when prices fall, rates rise.
That's what markets endured in 2022 as the Fed let bonds it held roll off (when the term of the bonds end and the issuer repays the principal to the Fed, the Fed does not reinvest the proceeds, thereby keeping it out of the financial system) starting in June. By September, the Fed was allowing up to $60 billion of Treasury securities and $35 billion of MBS to mature without the proceeds being reinvested. While it was a similar program to what Powell led from 2017 to 2019, the latest QT round was much faster, helping to bring about more macro volatility.
Such a swift change in tone from intense stimulative QE measures during the Covid crisis to extremely tight monetary policy by late 2022 was driven by inflation. The year-on-year rise in the U.S. Consumer Price Index (CPI) surged above 8% and held there for much longer than economists expected. Moreover, a climbing U.S. dollar along with the conflict in Ukraine made inflation that much worse in Europe. By late 2022, the ECB debated how soon it should launch QT given its unique risks to both growth and surging commodity prices. The BoJ remained steadfast in its dovish policy despite an 8-year high in inflation.
What It All Means for You
Market volatility is now front and center. Stocks have fallen sharply off their early 2022 highs while the global bond market endures one of its worst bear markets of all time. The era of zero interest rate-policy (ZIRP) is over and investors must reassess how they manage their portfolios.
Record-low interest rates ushered in and promoted by the Fed, along with several fiscal stimulus packages during the pandemic, led to a period of excess speculation. Meme stocks, initial public offerings (IPOs), special-purpose acquisition vehicles (SPACs), biotech companies, and even cryptocurrency all swelled in value. As soon as the tone at the Fed shifted from QE to QT, however, the air was let out of the bubble. The crash of 2022 took place after Bitcoin neared $70,000 and some stay-at-home stocks saw their market caps surge above $50 billion or more.
Of course, you cannot blame it all on the Fed, though they deserve a lion’s share of the criticism. Many pundits and economists can wave fingers at the monetary authorities for being late to the inflation scene, but a host of factors were at play to drive up speculative fervor in late 2020 through 2021. Other central banks around the world maintained highly accommodative policies along with the FOMC. Additionally, Congress put through enormous stimulus and aid packages aimed at corporations, small businesses, and consumers.
It is also important for investors to recognize that financial markets always go through boom-and-bust cycles. Steep stock market rises are often followed by severe bear markets.
For young investors, now can be a great time to get started investing and to rethink your allocation. While prices on many stocks have retreated, the true value of those shares has perhaps not fallen by quite as much. For older investors more sensitive to risk, there are finally decent yields to be had in the bond market after years of rates being near zero percent, all thanks to this new regime.
Still, today’s inflationary times make it all the more important that your portfolio is aligned with today’s risks and your long-term goals. Allio’s macro portfolios are built using full-scale optimization to address all of these challenges and macro headwinds. By investing with us, you can access both traditional and alternative investments including real estate, emerging markets, crypto, and gold.
Even when you see markets dropping day after day, the key is not to panic, but to take a long-term holistic view. Recent market turmoil is no doubt jarring but like in prior bear markets such as the dot-com crash, the GFC, and even the short-lived Covid crash, staying invested is the key to building long-term wealth.
The Bottom Line
Quantitative tightening has caused a spike in volatility across all asset classes. The easy-money policy, which included a prolonged period of QE, is over. New care must be taken to effectively navigate today’s investing landscape.
Allio’s all-in-one investing app helps everyday investors position themselves in portfolios managed by professional risk managers and industry experts using tactics that historically have only been available to large institutions, asset managers, or hedge funds.
Here at Allio, we recognize the importance of balancing risk and reward, and of avoiding large losses. Our portfolio construction process focuses on the downside tails of the return distribution—in an attempt to make our portfolios as resilient as possible to market turbulence.