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Fed QT is Bull's Death Knell

Adam Hamilton
Sep 28, 2018

The Federal Reserve's unprecedented quantitative-tightening campaign is finally ramping to its full-steam speed in Q4. That will destroy $50b per month of quantitative-easing money created out of thin air! QT will need to maintain this terminal pace for over two years to meaningfully unwind the Fed's grotesquely-bloated balance sheet. This record tightening poses a dire threat to today's QE-inflated overvalued stock markets.

This week traders are focused on the Fed's 8th rate hike of this cycle, which was universally expected. Ever since the FOMC's previous meeting in early August, federal-funds futures have implied odds of another hike way up at 91% to 100% at this latest meeting. But the Fed's ongoing hiking pales in comparison with what it's doing with its balance sheet. One year after its birth, quantitative tightening is hitting full speed.

Rightfully concerned about QT's impact on the lofty stock markets, the Fed prudently took an entire year to ramp it up to terminal velocity. QT started almost imperceptibly at $10b per month in Q4'17, before being ratcheted up another $10b monthly in each subsequent calendar quarter. The final increase is going into effect in this imminent Q4'18, taking QT to a staggering $50b-per-month pace. That's record tightening!

QT is incredibly bearish for today's record-high, bubble-valued stock markets late in a record bull that was largely driven by the Fed's earlier extreme quantitative easing. QE conjured literally trillions of dollars out of thin air to keep interest rates artificially low, greatly boosting stocks in multiple ways. QE left bond yields uncompetitive with stock dividends, "justified" extreme stock overvaluations, and fueled epic stock buybacks.

QT threatens to reverse all that, restoring interest rates to more-normal levels. That will ultimately wreak havoc in stock markets heavily dependent on anomalous suppressed interest rates. Rising bond yields will attract back income-seeking investors, sucking capital out of far-riskier dividend-paying stocks. And higher rates will make it much more expensive for corporations to borrow money to buy back their own stocks.

In order to grasp QT's dire threatto these stock markets, we have to understand how they got way up here. This first chart superimposes the flagship US S&P 500 broad-market stock index (SPX) over the Fed's balance sheet since 2009, the entire span of this monster stock bull. The orange line is the Fed's total balance sheet, inside which is stacked total US Treasury QE in red on top of mortgage-bond QE in yellow.

This is the big-picture overview of almost the entire modern QE era, which started in late 2008 in response to the first stock panic in a century. In a single month ending in late October 2008, the SPX plummeted a catastrophic 30.0%! The Fed panicked as stocks cratered, fearing that a colossal negative wealth effect would paralyze our country. If Americans' spending slowed enough, it would literally trigger a depression.

So the Fed slashed its federal-funds rateaggressively, going to zero in mid-December 2008. Once a zero-interest-rate policy is hit, no further rate cuts are possible. So the Federal Reserve proverbially fired up its printing presses to create vast amounts of new money out of thin air. Euphemistically called quantitative easing, those conjured dollars were plowed into bonds to force other interest rates down to artificial lows.

This Fed-QE era ran from late 2008 to late 2014, and the stock markets ominously mirrored the growth in the Fed's balance sheet. When various QE campaigns were in force buying bonds to stack on its books, the stock markets relentlessly climbed. But whenever QE paused between campaigns, the SPX either corrected or stalled out. The Fed's wildly-unprecedented QE money printing directly fueled a massive stock bull!

In 2015 and most of 2016 without new QE bond buying, the stock markets ground sideways and started to suffer corrections again. They only decisively broke free from that no-QE funk following Trump's surprise election victory in November 2016. Hopes for big tax cuts soon drove enough greedy sentiment to finally overcome the lack of QE momentum. That blasted stock markets deep into record territory on many fronts.

While the Fed had stopped printing money to buy bonds in late 2014, it inexplicably waited several yearsuntil late 2017 to finally start unwinding that epic QE. The QT era started a year ago and has accelerated strongly in 2018. The euphoric stock markets are ignoring the Fed's shrinking balance sheet for now, but it's only a matter of time until QT stokes serious selling. That's when stocks' long-overdue reckoning will start.

Before digging deeper into QT's very-bearish implications, let's consider the QE era between roughly 2009 to 2015. This chart is one of the most-damning in stock-market history, showing how the SPX's bull market perfectly mirrored the Fed's balance sheet! QE literally levitated the stock markets, pushing them inexorably higher while short-circuiting normal healthy corrections. Selling only returned between QE campaigns.

What would later become known as QE1 started in late November 2008, with the Fed announcing $500b of buying in mortgage-backed securities and $100b in agency debt. In the first 8 months of 2008 before that stock panic, the Fed's balance sheet averaged $849b. But by mid-November it had skyrocketed 152% to $2173b in just 11 weeks on the Fed's frantic emergency measures to respond to that stock panic!

That extreme stock selling didn't finally exhaust itself until March 2009, after the SPX had plunged 56.8% in just 1.4 years in a wicked bear market. While stocks normally surge out of panics, the SPX was down another 25.1% year-to-date due to fears of crushing income-tax hikes from Obama's new administration. So a terrified Fed dramatically expanded QE1 in mid-March, spinning up its printing presses to high speed.

In QE1X the Fed pledged to buy another $750b of MBSs to force mortgage rates lower to keep the US housing sector moving. It is a key driver of national economic activity. The Fed also said it would double its agency-debt purchases with another $100b of buying. But the really stunning development was the Fed's first-ever declaration of extensive direct monetizationof US Treasury bonds to the tune of $300b.

That's the kind of thing you see in banana republics leading to hyper-inflation, local central banks printing new money to buy up their government's debt! That enables the government to run huge deficit spending, greatly distorting normal interest-rate signals that limit living beyond means. Together QE1 and QE1X totaled $1750b. The SPX soared 79.9% higher at best in essentially that QE1 span in a giant post-panic bounce.

But stock traders realized the SPX was shooting higher in lockstep with the Fed's Treasury purchases. So when QE1 started nearing the end of its pre-announced buying in late June 2010, fears mounted. The SPX started rolling over and ultimately corrected 16.0% in 2.3 months. While corrections are normal and healthy in bull markets, the first one of this bull didn't ignite until QE1 was ending. That spooked the Fed.

It feared without QE the young stock bull would falter, reigniting bearish psychology that would drag down spending and thus overall US economic activity. So in August 2010 the Fed declared what would soon be known as QE2. It said it would roll over $300b in maturing MBSs into Treasuries, effectively doubling their direct monetization. The Fed reneged on its original QE1 promise to let those bonds unwind as they matured.

In early November 2010, the Fed announced a QE2 expansion. In QE2X it would buy up another $600b of Treasuries with new money wished into existence by June 2011. That would work out to about $75b per month of bond buying. Stock traders loved this unprecedented easing and bid the SPX dramatically higher over QE2's span. At best by April 2011, the SPX had rallied another 33.3% out of its correction lows.

But once again the stock markets anticipated the imminent end of QE2. After already soaring 101.6% bull-to-date in 2.1 years, would the bull be able to sustain the end of the Fed's stock-panic-grade easing? There were serious doubts, as evidenced by the SPX correcting 19.4% in 5.2 months mostly after QE2's Treasury monetizations wound down. That was right on the verge of entering a new bear market at -20%!

During that QE2 era, a staggering 70%of US Treasuries issued were purchased by the Fed with money conjured ex nihilo! In early August 2011 Standard & Poor's downgraded the US's AAA debt rating for the first time in history. That was partially on concerns the already-enormous Obama deficits would explode without the Fed's QE keeping interest rates artificially low. The Fed panicked with the SPX on the edge of a bear.

In late September it announced what became known as Operation Twist. The Fed would attempt to "twist" the yield curve by selling $400b of short-term Treasuries under 3 years maturity to plow that $400b into long-term Treasuries maturing in 6 to 30 years. That would actively manipulatelong rates lower, taking pressure off the US government's enormous debt load and helping hold down US mortgage rates as well.

The SPX rallied sharply on that continuing Fed interventionism, surging another 29.1% into April 2012. But with Twist's $400b about expended, stock traders again worried about what would happen to the SPX without a hyper-easy Fed. So just like after QE1 and QE2, the SPX started selling off again. By early June it had lost 9.9% threatening another correction. So that very month the Fed decided to expand Twist.

It announced adding on another $267b of yield-curve twisting, about $44b a month for 6 months. The SPX rallied again on that ongoing long-rate manipulation, which the Fed openly admitted to in its FOMC statements! But by mid-September, the SPX was stalling out again. It had barely crested its April high and momentum was flagging. After QE1, QE2, and Twist, the Fed had learned important lessons about traders.

They happily bought stocks as long as the Fed was monetizing bonds through quantitative easing. But since all those QE campaigns' sizes and effective end dates were declared in advance, the traders would anticipate their endsand start selling. The stock markets were slaved to the Fed's QE, which was a dangerous easy-money drug. The QE-fueled SPX bull was maturing and slowing, up 112.5% in 3.5 years.

The Fed's extensive research has long shown that stock-market fortunes color the psychology and thus spending and economic activity of the entire country. There was mounting political pressure on it from the Republicans to stop monetizing debt which enabled Obama's enormous deficits. The Fed didn't want to either kill the stock bull or be blamed for slaying it, so it decided to try something different with a new QE3.

Birthed in mid-September 2012, QE3 was radically different from QE1, QE2, and Twist in that it had no announced limits. The Fed declared it would start purchasing $40b per month of MBSs, but didn't say how long it intended to do so. Thus QE3 was open-endedwith no predetermined size or duration! While its declaration sparked a sharp couple-day SPX rally, those gains quickly faded to a 7.7% loss by mid-November.

So in mid-December the Fed doubled down with a QE3 expansion just as it had done with all its prior QE campaigns. QE3X added on another $45b per month of open-ended Treasury monetizations. Stock traders were ecstatic, and started relentlessly buying stocks in 2013 and 2014. Thus the SPX floated up in a stunning levitation unlike anything ever witnessed before. The Fed wielded QE3 to control traders' psychology.

Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory. Traders realized that the Fed was effectively backstopping the stock markets! So greed flourished unchecked by corrections.

The Fed's QE3-expansion promises so enthralled traders that the SPX went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever! With the Fed jawboning negating healthy sentiment-rebalancing corrections, psychology grew ever more greedy and complacent. The SPX surged another 40.5% in that crazy QE3 era, extending its bull to 198.3% over 5.6 years.

QE3 was finally wound down in October 2014, leading to this Fed-evoked stock bull soon stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would've happened! Without more QE to keep inflating stocks, the SPX ground sideways and started topping. Corrections resumed in mid-2015 and early 2016 without the promise of more Fed QE to avert them.

They were relatively minor at 12.4% over 3.2 months and 13.3% over 3.3 months, but the writing was on the wall. Without extreme Fed easing, the mighty SPX was starting to roll over. An anomalous extreme QE-fueled stock bull was struggling to stand on its own once the Fed's easy-money flood dried up. There is no doubt the Fed's bond monetizations largely drove if not dominated the SPX from early 2009 to early 2016.

2013 was the peak-QE3 year, when the Fed monetized a staggering $1020b in bonds through QE. Such vast central-bank liquidity injections catapulted the SPX 29.6% higher that year! The Fed tapered QE3 in 2014, which added up to $450b of additional bond buying that year. And the SPX only rallied 11.4%. Fed QE dropped by 56% between 2013 to 2014, and stocks' rallying shrunk 62%. That's certainly no coincidence.

Then in 2015 when Fed QE was zero, the SPX slipped 0.7%. See the pattern here? The more QE from central banks, the more the stock markets rise. Those vast capital injections from the Fed levitated the US stock markets by forcing yield-starved bond investors into stocks and facilitating immense corporate stock buybacks. This QE-driven stock bull peaked in mid-2015 soon after the Fed ceased its own QE!

QE3 ultimately ballooned to a staggering $1590b, rivaling QE1 in scale. And its $790b in direct Treasury monetizations dwarfed those in all the preceding QE campaigns. Starting in 2008's stock panic, the Fed's total QE soared to $3625b over 6.7 years. That catapulted its balance sheet a staggering 427% higher, from $849b before the stock panic to a peak of $4474b in February 2015! That was unprecedented in history.

The Fed literally created $3.6t out of thin air to use to buy bonds with the express stated goal of actively manipulating interest rates lower. The SPX surged higher in lockstep with the Fed's ballooning balance sheet during QE money printing, but corrected whenever it paused. The evidence is crystal-clear in this chart. This stock bull that more than tripled with a 215.0% gain by May 2015 was directly driven by Fed QE!

Odds are the dominant reason the overdue stock-market bear didn't arrive in 2015 was the European Central Bank accelerated its own QE campaign in March that year. The ECB effectively took the QE baton from the Fed, keeping world stock markets levitated through massive liquidity injections. ECB QE levitated European stock markets through the same mechanisms as the Fed QE had earlier levitated US ones.

The global stock markets are heavily interconnected. Both rallies and selloffs in either the United States, Europe, or Asia usually create the psychology necessary to drive similar moves in the other markets. So the ECB's QE directly buoying European stock markets bled into US stocks, fending off the overdue bear that the end of the Fed's QE should've awoken. It was hopes for more ECB QE that rekindled this tired bull.

The Fed's QE3 bond buying was tapered to zero by November 2014. From that announcement in late October that year, the SPX would rally another 7.3% into May 2015 on sheer momentum and euphoria. After that it drifted sideways to lower for the next 13.7 months, suffering two corrections. It wasn't until July 2016 that a new bull high was finally seen. That was soon after the UK's surprise Brexit vote to leave the EU.

That June 2016 referendum stunned European leaders, potentially threatening their entire project to unite Europe. Thus the ECB's central bankers rushed to vociferously promise to do anything necessary to maintain market stability through the Brexit process. So the SPX only broke out of its mounting bear trend thanks to hopes for more ECB QE! That rally soon fizzled until Trump's surprise victory unleashed Trumphoria.

With Republicans sweeping the presidency and both houses of Congress, stock traders started salivating at big coming tax cuts. That greedy psychology fed on itself and multiplied, with buying begetting buying pushing the SPX sharply higher. So despite the stagnant monstrously-bloated Fed balance sheet, the SPX surged another 34.3% higher between early-November 2016's election day and January 2018's peak.

Euphoria soared to extremes in late 2017 and early 2018, spurred on by the advancing of Republicans' massive corporate tax cuts. The SPX rallied first on the progress being made in Congress, then on that tax-cut bill's passage, and finally on these tax cuts going into effect in January 2018. That once-in-a-lifetime taxphoria drowned out everything else, including the ominous dawn of Fed quantitative tightening.

Nearly 3 years after it stopped monetizing bonds via QE, the Fed finally announced QT in late September 2017. It was inarguably one of the most-important and consequential decisions in the Fed's entire 105-year history! The Fed didn't want to keep that $3.6t of new QE money injected into the system forever. But it couldn't muster the courage to start gingerly reversing QE through QT until the SPX had surged way higher.

The Fed still fully realized QT was very risky given the stock markets' interactions with QE and its pauses for the majority of this bull market. So it cautiously launched QT in Q4'17 at a mere $10b-per-month rate. It would allow $6b in Treasuries and $4b in mortgage-backed securities to roll off its balance sheet each month as they matured. There would be no outright selling. To say the SPX responded well is an understatement.

That $10b monthly QT was supposed to add up to $30b in that maiden quarter, a drop in that $3625b bucket of total QE. The Fed only reports its balance-sheet data weekly, so there's no daily-resolution read. But between late September 2017 to early January 2018, the balance sheet only shrunk by $16b. Thanks to the late-December passage of the Tax Cuts and Jobs Act of 2017, the SPX surged 6.1% that quarter.

In originally announcing QT, the Fed had stated it planned to add $10b per month of bond rolloffs each calendar quarter at that same ratio of Treasuries to MBSs. That would gradually ratchet up QT to its final terminal pace of $50b per month in Q4'18, consisting of rolloffs of $30b and $20b of Treasury and MBS bonds. In Q1'18 QT was supposed to run at $20b per month, and the Fed's balance sheet shrunk about $66b.

Despite lots of skepticism, the Fed was actually ramping QT as planned! That proved a worse quarter for the SPX, which slumped 1.2% after a sharp-yet-shallow-and-short 10.2% correction in early February. While that resulted from the SPX shooting vertical in taxphoria, it's still interesting its first correction in 2.0 years coincided with QT spinning up. In Q2'18 QT was scheduled to expand again to $30b per month.

And much to the Fed's credit, it really did. From the last weekly balance-sheet reporting before Q2 to the first one after it, the Fed's balance sheet shrunk $97b. But a sharp diversion developed between this accelerating Fed tightening and the stock markets. The SPX surged 2.9% in Q2 on resurgent euphoria in the market-darling mega tech stocks. Intoxicated by near-record-high stock markets, traders ignored QT.

In this just-finishing Q3'18, QT was supposed to climb to $40b per month. While the Fed's final quarterly balance-sheet data wasn't yet released when this essay was published, QT was roughly on track at $99b. And the stock markets continued climbing despite this record Fed tightening, with the SPX surging 6.9% quarter-to-date as of Wednesday. The Fed's QT has indeed unfolded just as promised over this past year.

While record-high stock markets certainly make QT easier to execute, the Fed is committed and knows it needs to unwind a sizable fraction of its $3.6t total QE. One big reason is to give the Fed room to launch more QE in the future in response to the next financial-market crisis. Reducing its balance sheet reloads its easing ammunition, just like its current rate-hike cycle makes room for future rate cuts. So full QT is a go.

It's scheduled to reach its terminal velocity of $50b per month in Q4! And since the Fed piled on that epic $3625b of QE, $50b of monthly QT would have to continue for some time to make a dent. The Fed itself has been clear its balance sheet will never shrink to pre-2008-stock-panic levels. But Fed watchers and economists generally agree the Fed will likely reverse half of that $3.6t in QE through QT, necessitating $1.8t.

The total planned QT in this past year's ramp-up stage between Q4'17 to Q3'18 added up to just $300b. That leaves another $1500b if the Fed is going to unwind $1800b of QE in total. At $50b per month, that would take 30 more months starting in Q4'18! So these euphoric stock markets are staring down the barrel of at least a couple years of full-steam QT. This is exceedingly bearish after stocks' long QE-fueled levitation.

Already there is a colossal divergence between the SPX surging to new records this past quarter and the accelerating shrinkage of the Fed's balance sheet. As of the latest data, it has fallen $244b or 5.5% year-to-date. How long can euphoric stock markets ignore the first major quantitative tightening in US history? While QE created money out of thin air, QT is destroying it. Vast liquidity being sucked out is bearish for stocks.

The main mechanism through which QE levitated the stock markets is corporate stock buybacks. With interest rates driven to deep artificial lows by Fed bond buying, corporations literally borrowed trillions of dollars to buy back their own stocks! That QE-enabled financial engineering boosted their stock prices as well as goosed earnings per share by reducing outstanding share counts. QT should strangle that scheme.

Without the Fed acting as a huge buyer of Treasuries, demand will be lower. That will push rates higher, increasing borrowing costs for corporations and the US government. Higher rates will not only curtail new stock-buyback-financing borrowing, but will make existing high corporate debt loads bite into earnings via higher interest expenses. Companies will have to shift capital from stock buybacks to paying down debt.

QT would be darkly ominous for QE-levitated stocks anytime, but is even more so now given their bubble valuations. Current profitability is far too low to justify today's lofty stock prices. At the end of last month, the 500 SPX stocks sported a simple-average trailing-twelve-month price-to-earnings ratio running way up at 31.5x! Anything above 28x is bubble territory. Weighted by market-cap, the average SPX-stock P/E is 34.7x.

Quantitative tightening has to be the death knell for wildly-overvalued stocks late in the 2nd-largest and 1st-longest stock bull in US history. As of late September it had soared 333.2% higher in 9.5 years, mostly thanks to extreme Fed QE along with 7 years of ZIRP and later corporate-tax-cut euphoria. This ancient bull is long overdue to fail anyway and die of natural causes, QT's bullet in its skull will only accelerate that.

On top of that, the European Central Bank's massive QE campaign that took over after the Fed stopped monetizing is wrapping up at year-end 2018. That will have totaled €2355b over 3.8 years, the equivalent of roughly $2657b. While not as large as the Fed's $3625b over 6.7 years, the ECB's QE proved more intense averaging $699b annually compared to the Fed's $541b. Fed QT combined with zero ECB QE is terrifying.

Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming central-bank-tightening-triggered valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power grows. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half-price!

Put options on the leading SPY S&P 500 ETF can also be used to hedge downside risks. They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.

Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early that year. When the SPX indeed rolls over into a new bear soon, gold's coming gains should be much greater. And they will be dwarfed by those of the best gold miners' stocks, whose profits leverage gold's gains. Gold stocks rocketed 182% higher in 2016's first half!

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The bottom line is the Fed's unprecedented quantitative-tightening campaign to unwind trillions of dollars of QE is just hitting terminal velocity. Even at $50b-per-month full-steam, QT would have to run for 30 more months to even unwind half of the Fed's $3.6t of QE! That's incredibly bearish for bubble-valued stock markets late in a monster bull mostly fueled by that very extreme Fed easing. QT is this bull's death knell.

Stock markets have never faced Fed QT at scale, they're heading into dangerous uncharted territory. They followed the Fed's surging balance sheet up as QE ballooned, so they'll almost certainly mirror the Fed-balance-sheet contraction as QT reverses QE. And with the ECB's QE soon coming to an end, ECB money printing won't exist to blunt the Fed's QT impact. QT is a dire threat to this QE-inflated bull, beware!


Sep 28, 2018
Adam Hamilton, CPA

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