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Quantitative tightening fears overplayed?

Tong Kooi Ong
Tong Kooi Ong2/1/2019 08:00 AM GMT+08  • 5 min read
Quantitative tightening fears overplayed?
SINGAPORE (Feb 4): Global stock markets have steadied in the first few weeks of trading in 2019, though many investors remain wary that the rebound may not last. The list of worries has been very well narrated and should be very familiar to all by now, on
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SINGAPORE (Feb 4): Global stock markets have steadied in the first few weeks of trading in 2019, though many investors remain wary that the rebound may not last. The list of worries has been very well narrated and should be very familiar to all by now, one of which is the US Federal Reserve’s quantitative tightening (QT) actions.

Recall that the Fed started QT in October 2017, by allowing a monthly fixed amount of Treasuries and mortgage-backed securities on its balance sheet to run off. The initial amount was US$10 billion a month, which subsequently was increased by US$10 billion every quarter.

Since October 2018, assets totalling up to US$50 billion monthly will mature without being reinvested. The Fed’s balance sheet peaked around US$4.5 trillion and has since been pared down to less than US$4.1 trillion ($5.5 trillion) at the start of 2019. It will further drop by up to US$600 billion this year assuming the US$50 billion monthly runoff rate, though Fed chairman Jerome Powell had recently signalled flexibility should the situation warrant it.

There is widespread consensus that quantitative easing (QE), in the aftermath of the global financial crisis, had the effect of inflating asset prices, including stocks and properties. Concerted efforts by major central banks effectively forced interest rates far below market-driven levels, thereby pushing investors further out the risk spectrum. That is, to take on more risks in the search for yields (see Chart 1).

Could the reverse, or QT, then have the opposite effect of dampening asset prices? Is it mere coincidence that the increased volatility and market selloff last year came at a time when the total assets of major central banks started declining — especially in 4Q2018 when the Fed’s runoff topped out at US$50 billion a month (see Chart 2)? Globally, property prices have also been falling.

While the question is not unreasonable, we suspect it is more noise than actual impact. Total global market capitalisation peaked at US$87.3 trillion in January 2018 and is currently hovering around US$73 trillion, which translates into a combined loss of US$14.3 trillion.

Meanwhile, the market cap for US stocks hit a high of US$32.5 trillion in September 2018 before losing some US$4 trillion to the current US$28.5 trillion or so. By comparison, the Fed’s assets fell just about US$136 billion in 4Q2018. Indeed, against these numbers, the annual US$600 billion reduction in the Fed’s balance sheet does not appear that significant.

Certainly, there are bigger risk factors at play. The impact of a full-blown trade war on global trade and economies would be substantially larger and with prolonged after effects. Investor worries of recession are not unfounded, especially given that economic growth around the world — including in China, which has been the main growth driver for the past three decades — is already slowing.

Gradual normalisation of interest rates, from near zero or negative territory, is also boosting the appeal of cash as a viable alternative asset to stocks and bonds. Case in point: A recent report by the Wall Street Journal indicated that investors were raising their cash holdings in portfolios at the fastest pace in a decade. According to Lipper data, assets in money market funds grew some US$190 billion in the last quarter of 2018.

Since the massive QE actions were unprecedented, we have little guidance of what could happen from a historical perspective. No one knows for sure the impact of QT on financial markets. But the worst of fears may have been overplayed, based on a gradual tapering scenario. In fact, QT actions may be short-lived. In reality, there are constraints as to how much the Fed can shrink its balance sheet on the liabilities side. Currency in circulation, in particular, has risen sharply, from between US$800 billion and US$900 billion pre-crisis to just over US$1.7 trillion at present. That is equivalent to a rise from less than 6% to more than 8% of nominal GDP (see Chart 3).

The Fed also holds reserves from foreign central banks, international agencies, nonbank entities, the US Treasury and so on — currently totalling about US$733 billion (see Chart 4). Add these to the required bank reserves, and the sum total of its liabilities (and matching assets) could be $3 trillion to US$3.5 trillion.

This would be the size of the Fed’s normalised balance sheet, which is not too far off from where it is now. At the current annual runoff rate of US$600 billion, QT would probably end in 2020.

The Fed has also sought to allay investor worries by signalling that it will hold off on further rate hikes for now, especially since inflation remains benign. This will boost the appeal of emerging market currencies, which were battered last year as the US dollar strengthened. Indeed, Asian markets saw relatively strong foreign fund inflows in January.

Stocks in my Global Portfolio ended broadly higher, up 3.76% for the week, buoyed by stronger sentiment. Last week’s gains, which outperformed the benchmark index, pared total portfolio losses to 10.0% since inception. Nevertheless, this portfolio is still underperforming the MSCI World Net Return Index, which is down by a lesser 2.5% over the same period. I would like to wish all readers good health and fortune in the Year of the Pig. Gong Xi Fa Cai.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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