It also has implications for the amounts of liquidity that have circulated in the US financial and global systems; implications that will be amplified if and when the European Central Bank and other central banks also follow through on their commitments to launch their own QT programs.
According to some estimates, more than $4 trillion in central bank purchases could be pulled from the markets over the next 18 months.
The combination of Fed rate hikes – it hinted at another 75 basis point hike next month and the likelihood of a near-zero fed funds rate early this year could be 3.4% at the end – and the beginning of QT means that the price of credit will increase even if its availability decreases.
If the Fed doesn’t blink an eye at the strong sell-off in the stock and bond markets, QT is as big a step into the unknown as QE.
QE had some unintended, or at least accidental, consequences.
Not the least of these has been a constant and ultimately almost complete erosion of all risk pricing, which has driven financial markets to extreme levels; levels that could only be justified by the absence of alternatives that could produce positive results and by the belief that the Fed and its peers offered a rising floor under all financial assets.
Inflation soaring to 40-year highs in this post-pandemic environment of supply chain disruptions, labor shortages, ongoing COVID outbreaks in China and market shocks in the energy and food resulting from Russia’s invasion of Ukraine have pulled these rugs under the markets.
The Fed can’t ignore an 8.6% inflation rate, just like the European Central Bank can’t ignore its 8% and rising rate or the Reserve Bank our 5.1% and rising rate. He, and the RBA, will do whatever it takes to eradicate inflationeven if it leads to another one of those recessions we have to have like the one Australia had in the early 1990s.
This is the transformation of the Fed from dove to falcon, almost overnight, which burst the bubbles it was largely responsible for creating in the equity and debt markets. It also blew up the most speculative and riskiest asset class of all, the crypto asset market.
With the U.S. equity market down about 23% year-to-date and the tech-laden Nasdaq market down about 33% from its peak from late last year, the market capitalization of crypto assets plunged from $3 trillion last October to around $880 today.
The crypto flagship, Bitcoin, traded at an all-time high of just under $70,000 last year and had a market capitalization of around $1.2 trillion. During the weekend it was trading as low as US$17,599 and, while it rebounded just above $20,000, the entire Bitcoin market is now valued at around $390 billion. Bitcoin turns out to be the main indicator of risk appetite in the market.
Just as QE – first deployed in response to the 2008 financial crisis, then doubled down in response to the pandemic – was unprecedented, so is QT.
While the realization that rates will rise steadily this year and continue to rise until inflation is brought under control explains why markets have crashed, there are already signs of reduced liquidity and a lack of depth of the markets which contributes to the size of the falls.
At this phase of opening QT, this would almost certainly be more attributable to investor and lender risk aversion (there are reports of significant levels of margin lending and subsequent market calls from cryptography) than to the Fed’s balance sheet strategies.
It is a radical change in attitudes towards risk that has the greatest impact on the markets.
In the bond market, fear that the value of bonds and the income they generate could be overwhelmed by inflation drove yields higher. At the start of the year, US 10-year bonds yielded 1.5% and two-year bonds 0.73%. They now yield 3.23% and 3.2% respectively.
In the junk bond market – the market for bonds issued by companies with poor credit ratings – the spread between bond yields and US Treasuries started the year at around 2.8 points. percentage. Today it is more than five percentage points.
All over the world rates are rising and credit conditions are tightening and unless something unpredictable happens rates will likely continue to rise until at least well into next year and central bank liquidity will continue to be withdrawn for several more years.
For governments, corporations and over-indebted households who have been encouraged for nearly a decade and a half to binge on cheap credit, it is a daunting prospect.
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