SynopsisAfter keeping interest rates low for years, the US Federal Reserve has taken to quantitative tightening. From September 1, the Fed started to reduce its holding of treasury and other securities by USD95 billion a month. The Fed just has to get it right, for the markets across the world depend on its moves.
Too Big to Fail, one of the bestselling books on business by Andrew Ross Sorkin, starts with a prologue where Jamie Dimon, CEO of JP Morgan Chase, is pouring himself a cup of coffee that might cure his headache.
One would agree with him as the date was September 13, 2008.
Dimon had just returned from an emergency meeting at the US Federal Reserve Bank with CEOs of rival Wall Street banks.
Sorkin writes that the assignment for the CEOs was to come up with a plan to save Lehman Brothers, the nation’s fourth-largest investment bank, or risk the collateral damage that might ensue in the markets.
Eventually, the Fed did save Wall Street, or for that matter, the entire financial system across the world. How, you’d ask?
It did that by using a technique called quantitative easing (QE).
The approach appeared to be straight out of Lewis Carroll’s Alice in Wonderland, where Alice takes all the risk and moves from one situation to another. The Fed, or more particularly the US treasury secretary at that time, Hank Paulson, has a story that rhymes with Alice’s actions.
Paulson thought that he could tell the world that he had a bazooka, and also show that he could sort out the crisis without firing a single shot. He eventually did that.
Sorkin had a detailed story about this in The New York Times.
Paulson’s bazooka was just like Alice’s Drink Me bottle. Later on in the tale, Alice also had the Eat Me cake. Paulson did not. He could resolve one situation but did not know that he should also have the means to sort out the next one, too.
Maybe he thought that he could simply wake up thinking that it was all a bad dream. Maybe he needed someone to warn him about the long-term consequences.
Alice keeps warning herself that every action she takes will have consequences. When she sees a bottle marked “Drink Me”, she warns herself several times that she shouldn’t do that. But left with no option, she does exactly that.
She first becomes tiny, and then large. Gradually, she keeps becoming tiny and large to get back to the right size.
QE is that bottle of Drink Me that the Fed had to go for as a quick solution to tide over the global financial crisis. Lower interest rates or QE is cool. But is it permanently cool? When the world went into a crisis, the Fed decided to lower interest rates to bring down the yields on government bonds that would eventually start a cycle of cheap money around the world.
The Eat Me cake is quantitative tightening (QT), using which the Fed will have to harden interest rates so that it can control inflation.
But when Alice eats that piece of cake, she immediately touches the roof. Only after a series of iterations of drinking and eating does she finally get herself out of trouble.
The Fed has been drinking itself tight. But now it is time to eat enough, which means raising the interest just enough so that it does not hurt the economy and calms down inflation.
Global financial markets are heading into an uncharted territory as the US Fed accelerates its plan of withdrawing liquidity from the system, or QT. To better understand QT, it’s first pertinent to know its predecessor, QE.
A different picture
After the 2008 global financial crisis, the arteries of the financial system were choked, as there were no buyers for sub-prime or mortgage-backed securities. To keep the system running, and avoid a total collapse, the US Fed offered a plan to buy these securities and inject money through this route into markets. This became necessary because even zero interest rates were not able to refloat the markets.
This asset-buying programme through various channels and simultaneous liquidity injection in the markets is known as QE.
The balance sheet of major central banks expanded from USD7 trillion to USD20 trillion between 2008 and 2018. After the pandemic, it expanded from USD19 trillion to USD31 trillion in just 24 months. QE became a new normal for markets flush with liquidity.
But now the Fed is facing a different problem. This time the labour market is strong, and US inflation is at a 41-year high. Interest-rate hikes alone won’t be enough to control inflation.
Therefore, the Fed has embarked upon QT.
This entails two steps. One, is to let the bonds or securities mature; and two, sell the securities in the market and suck out liquidity. The withdrawn liquidity is then cancelled in the books of the US Fed, thereby reducing the size of its balance sheet, which has ballooned over the years.
This process, which started in June and picked up pace starting this month, is known as QT.
Liquidity typically means all cash and credit available to financial markets, after transaction requirements of the economy are met.
Withdrawal of liquidity can have negative implications for both equity and debt markets. It’s already making the dollar strong enough to hit emerging market currencies.
“Federal Reserve chairman Powell finally spoke firmly to fight inflation. Reminds us of Paul Volcker who broke the back of US inflation in the 1970s and 1980s. Watch out for quantitative tightening (QT). The US rules the financial world. Opiated markets will wake up and smell the coffee!” managing director and CEO of Kotak Mahindra Bank, Uday Kotak, said in a tweet on August 29.
Kotak is among a number of financial-sector executives warning about the risks of QT.
Rohit Srivastava, founder and market strategist at research company indiacharts.com, wrote in a report on August 30: “The post-pandemic combination of central bank liquidity and fiscal spending expanded credit and money supply far enough to stoke an inflationary trend that is stronger and felt globally. The breakdown of the supply chains and de-globalisation trends, like the silent war with Russia, has made it even more difficult to cool down the inflationary pressures. Thus, in an attempt to control the inflation animal, we are in a unique situation where central banks worldwide are simultaneously tightening monetary policy and liquidity.”
He added, “This is typically not good for the economy. So, on the one hand, rising wages are fuelling demand and pushing up PPI (producer price index) that is keeping equities elevated and hope of a revival in the stock market alive. Tightening liquidity is pulling down the valuation multiples that the market can assign to stocks. This can confuse participants that do not see it this way.”
The US taper, eight years ago, involved winding down a USD85 billion monthly purchase programme in a span of 10 months in 2014. Now, a USD120 billion monthly purchase programme has been wound up in four months by March 2022. Coupled with a series of interest-rate hikes and an expanded QT programme means a significant amount of liquidity will flow out of the system.
Before the 2014 taper, the Fed expanded its balance sheet by around USD3.1 trillion over a period of 64 months. In response to the pandemic, the Fed’s balance sheet has expanded by USD4.6 trillion in 18 months from March 2020 and October 2021.
From September 1, the Fed started to reduce its holding of treasury and other securities by USD95 billion a month. The European Central Bank is expected to follow suit sooner than later. Analysts expect the US Fed’s balance sheet to fall by nearly 15% of GDP by end-2024 in total, good enough to depress or contain valuations across asset classes.
The Fed’s QT move has proved to be disruptive and painful for all segments of financial markets — from equity to debt and commodities to currency. Emerging-market economies are feeling the tremors as the rise of the US dollar forces a sharp fall in their currencies.
Speaking of Indian markets, on July 14, the Indian rupee fell below INR80 for a dollar for the first time. The rupee, currently at 79.87, is trading with a negative bias as the dollar remains strong.
In the backdrop of rising interest rates and unwinding of liquidity, the US dollar index, or the DXY, has been rising relentlessly since May last year. From a low of 89.5 on May 25, 2021, to 110.63 on September 7, 2022, the index has scaled the levels not seen since July 2002. This has led to emerging-market currencies cracking against the US dollar.
The DXY measures the value of the US dollar against six foreign currencies — the euro, Swiss franc, British pound, Canadian dollar, Japanese yen and Swedish krona — with the euro having the highest weight of 57.6% in the index.
More than corporate earnings, liquidity injections by global central banks, led by the US Fed, have become a key driver of stock markets since the global financial crisis in 2008-09.
A reversal of this process can have severe negative implications. This is a key risk to watch out for.
(Graphics by Mohammad Arshad)(Originally published on Sep 9, 2022, 12:01 AM IST)
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