A twist on the Fed’s bond roll-off program … bad results the last time we did this … are we headed toward a liquidity problem? … a special event today with Luke Lango

We’re stepping into uncharted waters tomorrow.

The end result could be massive volatility – not just in U.S. stocks, but in global financial markets in general.

To understand what’s happening, let’s back up…

Stocks love quantitative easing (QE).

That’s because QE is the financial equivalent of getting a bonfire going by spraying a flame with gasoline.

To make sure we’re all on the same page, QE is a monetary policy strategy used by central banks around the world in which the bank purchases various securities – think bonds, federal agency debt, and mortgage-backed securities.

The goal is to increase the supply of money sloshing around the economy. Hopefully, that leads to more businesses and consumer lending, which stimulates the economy.

Of course, much of the sloshing money inevitably finds its way into the stock market (either directly or indirectly), which helps drive up prices.

So, stocks love QE.

We can see this love is by going back to the period between 2008 and 2013

That’s when then-Federal-Reserve-Chairman Ben Bernanke doused the market with QE.

We’ll show you the chart in a moment, but here are the numbers:

• QE 1 from December ’08 through March ’10: the S&P gains 42%.

• After QE 1 stops: the S&P falls 11%.

• QE 2 from November ‘10 through June ‘11: the S&P gains 24%.

• After QE 2 stops: the S&P falls 14%.

• Operation Twist from September ‘11 through June ‘12: the S&P gains 24%.

• After Operation Twist stops: the S&P falls 6%.

• QE 3 from September ‘12 through April ‘13: the S&P gains 16%

Here’s the crude version of how that looked.

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

Source: StockCharts.com

Okay, so what’s the point? And why is it relevant to these “uncharted waters” we’re stepping into tomorrow?

Well, back in June, the Fed began doing the reverse of quantitative easing – quantitative tightening (QT).

And beginning tomorrow, it’s putting the pedal to the metal, speeding up the pace of that QT – doubling it, in fact.

Now, a question…

If stocks love quantitative easing, wouldn’t logic suggest they won’t love an accelerated version of quantitative tightening (QT)?

What’s coming tomorrow, and the swirl of uncertainty accompanying it

As of June 1, the Fed began shrinking its $8.9 trillion balance sheet as a pace of $47.5 billion per month.

Specifically, the Fed has been running-off $30 billion of Treasuries and $17.5 billion of mortgage-backed securities each month.

Beginning tomorrow, the amount of this run-off will double to a combined $95 billion.

Is this a big deal?

Yes. Although, to be fair, no one is certain of exactly how big of a deal.

But to try to ballpark it, history does offer a precedent.

From Financial Times:

The Fed staged a dress rehearsal for QT beginning in 2017, gradually shrinking its balance sheets in a process then Fed chair Janet Yellen said would be so predictable it would be like “watching paint dry”.

In fact, it ended up having to be abandoned after September 2019 when the plumbing of the financial system gummed up and overnight borrowing costs skyrocketed. 

More directly relevant to your portfolio, that 2017 roll-off campaign, combined with rate hikes from the Fed, resulted in the Christmas 2018 stock market meltdown.

From October through Christmas, it was a peak-to-trough collapse of 20% in the S&P, punctuated by a drop of nearly 3% on Christmas Eve.

Now, consider that the peak bond runoff amount from the Fed at that time was $50 billion a month.

Tomorrow, the Fed basically doubles that amount…with elevated interest rates…that are headed higher…during a period of high inflation.

So, what will happen?

No one truly knows.

Earlier this summer, Fed Governor Christopher Waller was transparent about this in a speech. He said that estimates “using a variety of models and assumptions” are “highly uncertain.”

And the minutes from the Fed’s May meeting reflected the same “who knows” shrugging:

Regarding risks related to the balance-sheet reduction, several participants noted the potential for unanticipated effects on financial market conditions.

The challenge is that economists say that quantitative easing is simpler to model than quantitative tightening. But most economists agree on the general economic impact of QT, and it’s negative.

From Brian Quigley, Vanguard head of MBS, Agencies, and Volatility:

The Fed stepping away as a buyer of the market will prompt a period of adjustment that will ripple across financial markets as valuations will have to cheapen to attract more price-sensitive buyers.

That this will be happening as a number of other major central banks will be hiking rates and unwinding their balance sheets is a complicating factor.

Now, a logical pushback…

The bond roll-off program began in June, and the stock market soared and the economy held up fine. Isn’t that evidence that this is a non-event?

No. The market soared because of a combination of bearish exhaustion and hopes of a dovish Fed pivot and slowing rate hikes. The Fed threw cold water on that in its Jackson Hole symposium last week.

Also “no,” because the timing of bond roll-offs and their impact on the economy/stocks is unclear, but history suggests a longer lag. For example, the most recent bond roll-off campaign started in the fourth quarter of 2017, but stocks didn’t crash for another year.

But stepping back, there’s more at stake here than merely stock prices.

The underlying issue is the risk of massive price swings in bond and debt markets due to illiquidity…which would send ripple effects out into the broader investment universe

From Bloomberg:

Policy makers, in a rush to rein in consumer prices, are quickly lifting interest rates and ending programs that made them the dominant buyers of government debt in places such as the US, Europe and Australia.

Investors have yet to pick up the slack, helping create a liquidity drought that’s led to historic swings in yields in recent months. 

“Worst we have ever seen,” is how Andrew Brenner, head of international fixed income at NatAlliance Securities, characterizes conditions in the bond market.

“Central banks ruined liquidity from what it used to be.”

Throughout global financial markets, weaknesses that have long been camouflaged by ultra-dovish monetary policies are now being exposed.

This is raising questions about painful disruptions that could domino into other markets – potentially broad economies.

Back to Bloomberg:

With US Treasuries serving as the risk-free benchmark for more than $50 trillion of fixed-income assets, extreme volatility in their yields could make it tougher for private-sector companies to raise capital easily and at the lowest possible cost.

The market gyrations also threaten to introduce chaos into what traditionally has been the preferred asset class for pension funds, retirees and others looking for the safest possible investment returns.

And all of this in turn could pose risks for the broader economy that eventually may force central banks to change their plans.

It’s against this backdrop that the Fed begins to double its bond roll-off amount tomorrow.

Buckle up.

Speaking of liquidity problems, if you’re running into your own cash-flow shortages, join Luke Lango this afternoon

I’ll let Luke explain what’s happening:

After an exhaustive 8-month research project, I’ve uncovered a little-known income investment that could hand you income yields as high as 500% in under a month.

Compare that with the average dividend yield for the S&P 500, which is 1.61% as I write.

I’ve gotten a peek at Luke’s research and it’s powerful – helpful for investors in both bull and bear markets. Plus, it has nothing to do with options or some sort of confusing financial security.

Today at 4 PM ET, Luke will be explaining all the details in a free event called the Rapid Cash Flow Summit.

If you’re facing your own cash-crunch today, this event is absolutely worth your time.

I’ll give Luke the final word:

If you’re tired of the bear market crushing your portfolio in 2022, and you want to punch back with a new investment strategy designed to thrive in a bear market, you’re going to want to tune into this special broadcast.

It may be your best chance to make money over the next 12 months.

Have a good evening,

Jeff Remsburg

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