Quantitative Tightening: What it Means for Your Investment Strategy

Jul 05 2022 | 3 min

The U.S. Federal Reserve (the “Fed”) made headlines on June 16 with an unexpected increase of 0.75% in the Fed Funds rate. In the same month, the Fed returned to quantitative tightening (QT) for the first time since July 2019.[1]

With US inflation at a 40-year high, the combined measures may be necessary, if not overdue. The move may herald a fundamental long-lasting shift in the way we invest.

A brief recap

The global pandemic in early 2020 threatened to put the US economy into freefall. To stimulate the economy, the Fed slashed interest rates and re-embarked on quantitative easing (QE).

QE is often explained as “printing money.” It involves central bank purchases of long-term securities, such as government debt, from the open market using newly created bank reserves, or “printed” money.

The release of such large amounts of capital lowers the cost of long-term borrowing, helping to stimulate economic activity.

The Fed acquired roughly $5 trillion in securities through QE during the two years leading to March 2022, roughly doubling its balance sheet. After shrinking 3.4% in 2020, the U.S economy grew 5.7% in 2021. The overall economic measures had the intended effect.[2]

However, the influx of such large amounts of money to the market posed inflationary risk. The last QE program run by Fed from 2009 to 2014 did not cause excessive inflation. Arguably, its effects were countered by deflationary pressures from other sources.

But the environment today is not deflationary. All main measures indicate that inflation is high and rising.[3]

What is QT and how does it work?

QT is the reverse of QE.

Instead of buying securities and injecting capital, QT entails allowing the debt securities to run off as they mature (i.e. capital is removed from the market as debtors repay). The payments received disappear or are “unprinted,” reversing the process by which the original money appeared.

The QT program set by the Fed is more aggressive than the previous one. After a three-month ramp-up, nearly $100 billion in assets will be removed from the financial system monthly, subject to adjustments in response to the overall economy. Some estimates forecast that more than $3 trillion could be retired in the next few years.[4]

The Bank of England began its QT program in March and other central banks are likely to follow suit.

What this means for investors

The combination of an uncertain economic environment and rising inflation makes the situation different from any crisis in the past two decades.

Typically, lower interest rates backed by QE address slowing economic growth, increasing access to capital and helping to counteract lower employment.

This time, neither lower interest rates nor QE are viable options due to high inflation and an already bloated Fed balance sheet.

QT is being adopted to fix the latter problem. QT means that more lower-risk securities are available for investment, and less capital is available for riskier investments.

If the above anti-inflation measures prove ineffective (for example, due to certain inflationary items such as oil being outside of the control of the Fed), we may enter a period of “stagflation,” a combination of high inflation, and low economic growth and employment.

In this case, it would be impossible to simply “buy the market” as we can no longer rely on economic growth to raise valuations or stable returns from bonds as high inflation would erode these gains.

So what is the answer?

How to respond

The predictions above affect the entire capital markets.

Many investment strategies in the past 10 years have not focused on value, but simply entailed buying a representative sample of stocks that mirror the growth of the market (an approach called “indexing”). This was a workable strategy as long the overall stock market kept rising.

The abundance of capital in the broader economy meant that companies with questionable business models could attract investments with decent valuations. In a challenged market no longer fueled by cheap money and government stimulus, high returns must be earned.

An investor can create a winning portfolio only through careful selection of companies and sectors through research and active management.

This process has no room for guesswork or luck. It involves a patient assessment of fundamentals (e.g. Is the company generating cash flow? Does it have a solid product and is the market ready for it?).

What to do next

Regardless of the macro environment—boom or bust, expansionary or contractionary—an investment advisor helps you base your decisions on facts and expertise.

Just as a diverse portfolio is more resilient than one concentrated in a particular stock or sector, a professional team of team of advisors is the best hedge against an unpredictable future.

As a leading provider of alternative investment solutions, The Family Office can assist families in preserving wealth in this new market environment. Contact your financial advisor today to discuss a plan for your family.

 

[1] Yardeni Research - https://www.yardeni.com/chronology-of-feds-quantitative-easing/
[2] Federal Reserve Economic Data - https://fred.stlouisfed.org/series/GDPC1#0
[3] Politico - https://www.politico.com/news/2022/05/04/fed-inflation-new-era-economy-00029928
[4] Market Watch - https://www.marketwatch.com/story/feds-quantitative-tightening-is-about-to-arrive-what-that-might-mean-for-markets-11654024143

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