Could the Federal Reserve’s pivot from quantitative tightening spell trouble for stocks?
Outgoing U.S. Federal Reserve Chair Jerome Powell’s recent remarks have sparked debate. Speaking at the National Association for Business Economics conference on October 14, Powell hinted that the Federal Reserve’s (the Fed) long-running quantitative tightening (QT) program – its methodical unwinding of the balance sheet bloated by pandemic-era stimulus – may be “coming into view” for an end.
While perceived as a relief for many equity investors, halting QT might not actually be the good news equities investors are hoping for.
Background
QT, launched in June 2022, has seen the Fed allow up to US$95 billion in bonds and mortgage-backed securities to roll off its balance sheet each month without reinvestment. In other words, as the bonds the Fed previously purchased under Quantitative Easing (QE), and held, mature, they aren’t replaced with additional purchases. QE becomes QT.
The QT process drains liquidity from the system (balance ‘run off’), effectively tightening financial conditions in tandem with rate hikes. Since its peak of nearly US$9 trillion, the Fed’s balance sheet has shrunk to about US$6.6 trillion, pulling reserves from banks and forcing private market operators to absorb more of the government’s ongoing debt issuance.
For equities, QT should be a drag. By running down the Fed’s balance sheet holdings of bonds, it reduces the amount of cash it hitherto injected into financial markets through QE-related bond purchases, and so reduces the pool of “easy money.” It also nudges up yields on Treasuries and other safe assets, making borrowing costlier for companies and consumers alike. The resultant higher yields traditionally tempt investors away from riskier stocks toward bonds, curbing the “risk-on” sentiment that fuel bull runs.
The problem is that equities have been soaring to record highs, and that reflects the fact that the Fed has not been engaging in much QT at all. In fact, thanks to “underhanded” liquidity injections via reverse repos and other tools, QE has continued uninterrupted. The Fed has not been taking liquidity out of the system.
Now, with those “secret packages” said to be exhausted, the Fed faces a crossroads. Ending QT could risk depleting bank reserves further if Treasury issuance floods the system with short-term bills – a manoeuvre some have referred to as “Treasury QE.”
The signal that matters
Powell’s speech was superficially ‘dovish’. He reiterated the Fed’s plan to halt QT once bank reserves dip “somewhat above” levels deemed “ample”. He indicated this point may be reached in the coming months, and the central bank is closely monitoring indicators to guide the decision to end the balance sheet runoff.
But buried in the optimism was a warning: Don’t expect the broad-market spray of traditional quantitative easing (QE); it will be targeted liquidity funnelled toward “real economy” priorities like defence spending, artificial intelligence capital expenditure (AI capex), and strategic resource buys.
Financial markets may not optimistically receive this news.
As Michael Howell observed, this “difference in complexion” could “worry” equities because it prioritises fiscal goals over broad liquidity support. U.S. banks, already jittery from recent regional sector woes (Zions Bancorp down 13 per cent on loan charge-offs), might hoard reserves, crimping lending to corporations. Less credit availability means tighter margins for leveraged firms, a direct hit to earnings multiples that have propped up the S&P 500’s 20+ price-to-earnings (P/E) ratio.
How ending QT could backfire on stocks
QT’s end is a double-edged sword that could be bearish for equities. First, halting QT signals the Fed’s tolerance for a larger balance sheet, potentially reigniting inflationary pressures. J.P. Morgan has warned that if fiscal spending (e.g., defence procurement) accelerates via Treasury bills, yields further out on the curve could spike as markets price in higher deficits. Higher-for-longer sentiment was what crushed stocks in 2022; a similar dynamic today could rotate capital out of tech-heavy indices again. Under the Fed’s ending of QT, liquidity directed to government priorities might bypass equities, leaving stock markets starved.
Powell also emphasised avoiding a 2019-style “money market strains,” where repo rates spiked amid reserve shortages. Ending QT now, with reserves at 10-11 per cent of Gross Domestic Product (GDP) (near “ample” thresholds per Fed Governor Waller), might seem prudent. But shifting to Treasury Bills (T-bill)-heavy issuance could exacerbate volatility if banks deplete reserves faster than expected. Meanwhile, gold’s surge could be signalling something in the system is about to break.
For equities, thinner liquidity has always meant sharper sell-offs on bad news.
Ending QT could flood short-term markets while long-end yields rise, stabilising the curve but at the expense of equity market multiples.
A fork in the road?
Powell’s pivot isn’t a full QE revival either. Well, not yet anyway. Reported tensions in repo markets demand vigilance, especially as the rosy interpretation of Powell’s comments – ‘more liquidity equals higher stocks’ – ignores the nuance that the Fed’s directional shift prioritises systemic stability over equity euphoria.
If “Treasury QE” funnels cash in a way that favours real-world recipients, such as defence, bypassing equity markets, we could see more losers than winners.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
