What is QT and why will it hurt stocks?

Investors have pressed the sell button after the Federal Reserve raised interest rates by 75 basis points, putting the relief-rally to bed.

Stocks are feeling the pain but where the salt in the wound starts to sting is with quantitative tightening (QT). QT is opposite to quantitative easing. QT means that the liquidity that was injected in the economy is set to be removed out of the economy.

Like Fed, like RBA

On June 15, US$15 billion worth of treasuries will mature without reinvestment, followed by more in two weeks.

Between treasuries and mortgage-backed securities, the monthly runoff will be capped at US$47.5 billion until September. Then those thresholds will double to a combined US$95 billion.

The balance-sheet unwind may prove so painful that it pays to think about how policymakers might start trimming the program even as it’s just getting started.

In Australia, the Reserve Bank of Australia is doing the same. Assistant governor Christopher Kent spoke about it on 23 May.

The first major maturities from the RBA’s portfolio will be about $2 billion worth of the July 2022 Australian Government bond, followed by $2 billion of the November 2022 bond. The maturity of the April 2023 bond is much larger, at slightly over $13 billion. Maturities will then step up again to be more sizable from 2024.

What does this mean?

QT is a different beast to interest rate hikes. Higher borrowing costs impact the price of credit, but they do not, on their own, destroy credit – they just make the rolling over of existing debt or the issuance of new debt more expensive or at least make it harder.

The sectors worst affected by rising rates are those relying on the extension of credit over the long-term. Think about where you will need to borrow for a long period of time? Examples are car loans, mortgages and retailers. Why retailers? Their operations rely heavily on capital investments and on operating leases, requiring companies to apply more resources toward servicing debt.

What is the impact on economic growth?

To determine what sort of impact QT could have on economic growth, we have to look at credit.

I will be referring to the US Federal Reserve for the purpose of this discussion.

The reserves that QT destroys are the foundation of credit created. Take this with a grain of salt for the moment since the US central bank reduced bank reserve requirements to 0 per cent in the pandemic. It is also the growth in credit that supports the level of demand, while the accelerated growth in credit supports the change in demand.

One mechanism by which this happens is banks extend fewer loans when they hold more debt. They will become incentivized to accumulate more United States treasuries (UST) and mortgage backed securities (MBS) as the Fed reduces its balance sheet. Lower credit growth and acceleration lead to lower economic growth. 

As reserves vanish, this pressures credit formation and the stock of credit, which will in turn make gross domestic product (GDP) and GDP growth lower. Total credit in the US is 2.8 times GDP, or US$56 trillion, which is 10 times the size of the monetary base. Not all reserves are equal as they move at different pace, but in the worst case, each US$1 of the monetary base destroyed can take up to US$10 of credit with it.

The search for safety

Despite the sea of red ink over recent times, questions still remain as to whether inflation has peaked and the market has bottomed. Whatever the case, where do you search for safety in this environment?

Listed real estate stocks are one sector; another is commodities. Companies that have pricing power. Why? Stocks that present a steady cash flow and have strong fundamentals are key.

Why, then, are these stocks getting sold off as well?

It seems like everyone’s ready to sell everything, that means it could be an opportunity to buy.

However, in closing, watch credit spreads carefully as QT continues. It’s likely that inflation will be bumped down on the list of headlines to watch.

Sources: Bloomberg, IRESS