The Fed’s second quantitative-tightening campaign already ramped up to full-speed in September, with dire market implications. The unprecedented scale of QT2’s monetary destruction dwarfs QT1’s, which crushed stock markets. With inflation raging out of control because of the Fed’s extreme quantitative-easing money printing, it has no choice but to run aggressive QT even though that imperils overvalued stocks.
Like many serious economic problems today, the Fed’s intractable money-supply-inflation mess was born in March 2020’s pandemic-lockdown stock panic. In just over a single month, the flagship S&P 500 stock index plummeted an apocalyptic 33.9%! Traders were terrified government-imposed lockdowns to fight the new COVID-19 virus would force a severe recession or full-blown depression, so they ran for the hills.
Fed officials joined in that panicking, deeply worried that the negative wealth effect from cratering stocks would crush consumer spending and thus the US economy. So the Federal Open Market Committee rushed to intervene, making two emergency inter-meeting federal-funds-rate cuts of 50 basis points and 100bp! But with the latter slamming the FFR back down to zero, the Fed was out of rate-cut ammunition.
So these elite central bankers making monetary policy decided to radically expand their already-underway fourth QE campaign. QE4 had been born about five months earlier in mid-October 2019, adding $275b to the Fed’s balance sheet in that span. At that same Sunday-evening meeting where the FOMC slashed its FFR 100bp, it pledged to monetize “at least” $500b in US Treasuries and $200b in mortgage-backed bonds.
The implied timeframe given for nearly quadrupling QE4 was short, “over coming months”. Astoundingly in just two weeks the Fed monetized $700b more in Treasuries, and in four weeks hit $201b of new MBS buying! By mid-April 2020 the Fed’s balance sheet had already skyrocketed a dumbfounding 53.1% in just seven weeks, mushrooming to $6,368b! QE4 conjured staggering amounts of dollars out of thin air.
Despite the stock markets already soaring on that epically-unprecedented tsunami of new money, top Fed officials inexplicably kept their monetary printing presses redlined for two more years! By mid-April 2022, the FOMC had monetized an unbelievable $3,288b of Treasuries and $1,368b of MBSs since the eve of that stock panic in late February 2020! That was the most-extreme money-supply growth by far in US history.
In just 25.5 months, the Fed’s balance sheet ballooned a stupendous 115.6% or $4,807b! Effectively the monetary base underlying the entire global US-dollar supply, it had been more than doubled in only a couple years! In mid-April 2022 when it finally peaked, that balance sheet weighed in at an outrageously-grotesque $8,965b. Launched before that panic, QE4’s total girth had quickly expanded to an insane $4,913b.
The FOMC’s mission of levitating US stock markets proved wildly-successful, as this next chart shows. It superimposes the benchmark US S&P 500 stock index (SPX) over the Fed’s total balance sheet. That includes all the Treasuries and MBSs it monetized, or created new money to purchase. The stock markets soared as the FOMC’s extreme-liquidity fire hoses deluged in, driving up US stock markets in lockstep.
The symmetry between the Fed’s monstrous balance-sheet expansion and that monstrous post-panic stock bull is remarkable. From its panic trough in late March 2020 to its latest all-time peak seen in early January 2022, the SPX soared 114.4% in 21.4 months! That’s pretty much identical to the 115.6% total balance-sheet expansion, which took a few months longer. That QE4 gorging was a huge boon for stocks.
That mighty QE4X-fueled stock bull’s swan song proved telling if not damning. Just two days after that last record high, the FOMC released the minutes from its mid-December-2021 meeting. That had proven an uber-hawkish one, with Fed officials’ outlook for their federal-funds rate tripling from two hikes in two years to fully six! And the FOMC had launched its QE4 turbo-taper to end bond monetizations by March.
But neither far-more-aggressive projected rate hikes nor the end of QE4 fazed stocks, as the SPX went on to carve four new record closes in the weeks after that meeting. But its minutes disclosed something new, that Fed officials had started discussing an early balance-sheet runoff. The FOMC was ready to start unwinding that QE4 money printing with QT2 way sooner than expected, early in the looming rate-hike cycle.
The mere threat of imminent QT slammed the S&P 500 1.9% lower that afternoon, which later proved the very birth of today’s confirmed bear market! Traders obviously knew QE4’s epic money creation levitated the SPX, so they feared the threatened QT2 would unwind those gains. When central banks buy bonds, they create money ex nihilo to do that. When they sell bonds, that money is sucked out of the system and vanishes.
Quantitative tightening directly unwinds quantitative easing, reversing the liquidity pumps from spewing new money to destroying existing money. That’s a huge problem for QE-levitated stock markets trading at dangerous bubble valuations. Exiting December 2021 as the SPX was cresting, its 500 elite stocks averaged lofty trailing-twelve-month price-to-earnings ratios of 33.6x! Bubble territory formally starts at 28x.
Fed officials were panicking again because inflation was raging out of control. Rising general prices are caused by relatively-more money chasing and bidding up the prices on relatively-less goods and services. Way back in 1963, legendary American economist Milton Friedman proved in his definitive book studying all of US post-Civil-War monetary history that “Inflation is always and everywhere a monetary phenomenon.”
After the Fed recklessly ballooned its balance sheet a foolish 115.6% in just 25.5 months, serious inflation had taken root. That vast $4,807b flood of new money was bursting out of financial markets driving up the prices on everything. Everyone running a household or business was suffering raging inflation, and not even lowballed government statistics could hide it. Headline US Consumer Price Index inflation was soaring.
For five years prior to that pandemic-lockdown stock panic and the FOMC going crazy with QE4X, the monthly headline CPI reads averaged mere 1.6% year-over-year increases. That was largely because the Fed’s balance sheet had shrunk 7.2% across that entire five-year span. The original QT1 campaign was the reason, which was undertaken to unwind huge monetary excesses of QE1, QE2, QE3 and their expansions.
General price levels really lag money-supply changes, since those take many months to worm their way into the real economy. While QE4X exploded in March 2020, the CPI didn’t first exceed the Fed’s 2% target until a year later with March 2021’s +2.6% YoY. Over the next few months, headline inflation kept mounting up 4.2%, 5.0%, and 5.4%. With the CPI soaring 7.0% YoY in December 2021, Fed officials panicked.
That’s when they dramatically boosted their rate-hike expectations, accelerated the slowing of QE4 bond monetizations, and started discussing QT2. All the aggressive FOMC monetary-policy decisions since are a frantic race to tamp down this out-of-control inflation directly spawned by QE4’s epic money printing. In mid-March 2022 as the CPI soared 8.5% YoY, the Fed launched a new hiking cycle lifting the FFR 25bp.
Fed officials’ rate-hike outlook proved another uber-hawkish surprise, expecting six more quarter-point hikes in 2022 alone! That more than doubled the previous dot-plot outlook from mid-December. But that QE4-driven inflation super-spike continued festering and growing, with April and May CPI reads up 8.3% and 8.6% YoY. So in early May at its next meeting, the FOMC hiked by 50bp for the first time since May 2000!
But the big news that day wasn’t that outsized hike, but the Fed giving its first official outlook for QT2. It would start in June with $47.5b of monthly bond runoffs, roughly 2/3rds Treasuries and 1/3rd mortgage-backed bonds. Then that would double in September to a terminal rate of $95b per month of monetary destruction! The Fed’s second quantitative-tightening campaign ever would prove both huge and small.
While QT2 utterly dwarfs QT1, it is still little compared to QE4X’s gargantuan monetary expansion. This next chart shows how the S&P 500 fared during QT1 and the FOMC’s last rate-hike cycle. That was in the few years right before the prior QE4-and-QT2 chart. QT1 ultimately proved so damaging to the QE3-levitated stock markets that it was not only prematurely abandoned but quickly replaced by the original QE4!
What’s now known as QT1 was the FOMC’s first quantitative-tightening attempt ever. Fed officials were worried about how markets would react, so they ramped QT1 incredibly gradually. It started at a mere $10b monthly pace in Q4’17, then slowly accelerated over an entire year to a $50b-per-month terminal velocity in Q4’18. During that lazy ramp-up year, the QE3-levitated stock markets easily shrugged off QT1.
Euphoric traders didn’t care about the parallel mounting Fed-rate-hike cycle either. The S&P 500 surged to a series of new all-time highs in Q3’18 even as the FOMC executed its eighth 25bp hike of that cycle. But once QT1 went terminal at $50b monthly, stock selling pressure greatly mounted. The Fed chair himself contributed, making a speech where he declared the Fed would keep hiking its FFR well past neutral.
That surging stock selling soon cascaded, bludgeoning the SPX a brutal 19.8% lower in just 3.1 months mostly during Q4’18! The SPX plummeted right to the edge of a new bear after the mid-December FOMC decision hiking rates for the ninth time. That didn’t surprise, but the Fed chair did during his subsequent press conference. He said the Fed would keep full-speed $50b-per-month QT “on automatic pilot” going forward.
The SPX collapsed 7.7% over four trading days after that QT threat, pressuring Fed officials to cry uncle! They had the luxury of caring about stock-market fortunes then because inflation was low after over a year of balance-sheet shrinkage. In the five years leading into that notorious December-2018 policy pivot, monthly headline CPI inflation had averaged just 1.5%-YoY gains. So the FOMC wouldn’t risk driving a bear.
The wildly-oversold SPX was due for a bounce, which soon accelerated after the Fed chair spoke again in early January 2019. He declared that the Fed was “listening carefully to markets” and was “prepared to adjust policy quickly and flexibly” including with QT. Late that month the FOMC capitulated, removing a reference to further rate hikes from its statement. In March the FOMC pledged it would end QT1 in September.
When that original quantitative-tightening campaign was first announced, Wall Street Fed whisperers figured it would half-unwind the $3,625b of money printing from QE1, QE2, and QE3. But by the time the dust settled on QT1, it had merely reversed 22.8% of those colossal bond monetizations because the Fed caved early. Then just seven weeks after the balance sheet’s nadir, the FOMC reversed hard launching QE4!
All-in, QT1 merely shrunk the Fed’s balance sheet by 16.2% or $725b over 2.4 years. QT1’s terminal velocity of $50b monthly only lasted three months before stock markets collapsed! It’s hard not to view that as a dismal failure, the FOMC didn’t have the fortitude to even unwind a quarter of the earlier QEs before giving up. Will today’s young QT2 which is larger and more violent than QT1 in every way fare better?
Back to that early-May-2022 FOMC meeting where QT2 was defined, it is ultra-aggressive compared to that failed QT1. QT2 started at $47.5b of monthly monetary destruction in June, dwarfing QT1’s $10b-per-month opening pace and rivaling its $50b terminal one! QT2 would take just three months to ramp to full-speed, compared to fully twelve months for QT1. And QT2’s $95b terminal velocity nearly doubles QT1’s!
The Fed’s new second quantitative-tightening campaign is a monster compared to its original. Yet even if $95b per month can be sustained without wreaking havoc in the financial markets and US economy, it would still take over 26 months at that terminal velocity to just half-unwind QE4! Odds are Fed officials will get scared again and pull the plug way before QT2 runs that long, even with inflation forcing their hand.
QT2 was supposed to get underway in June, although the Fed didn’t do much bond selling. Balance-sheet data covering that month showed Treasuries only shrunk $5.5b while MBSs still grew $1.9b! That $3.6b of net QT was a tiny fraction of the $47.5b promised! But with CPI inflation soaring up 9.1% YoY in its hottest levels since November 1981, the FOMC accelerated its rate-hike cycle with a 75bp behemoth.
Stock traders had been expecting that largest Fed rate hike since November 1994, fleeing in anticipation leading into that mid-June FOMC meeting. Two days before, the SPX plunged into formal bear territory down 20%+ from early January’s record high! Top Fed officials hiked anyway, so this biggest inflation super-spike since the 1970s is overriding stock-market worries. The fabled Fed Put has a lower strike price.
In late 2018 when inflation was normal, a 20% SPX decline halted the Fed dead in its tracks. At some point this time around, Fed officials will likely capitulate again. Maybe this new bear fueled by extreme Fed tightening needs to hit -30%, -40%, or -50%, but eventually stock-market losses will grow so big that they threaten a negative-wealth-effect-driven depression. And QT2 as advertised will greatly imperil stocks.
The Fed reports its balance-sheet holdings weekly current to Wednesdays. QT2 accelerated some in the span best covering July, but still only netted out to just $21.7b which was less than half of the $47.5b pledged! But with CPI inflation continuing to run red-hot surging 8.5% YoY that month, the FOMC hiked another 75bp at its late-July meeting. Yet the SPX still surged after a dovish press conference by the Fed chair.
He declared the FFR was “now ... at neutral” so “at some point, it will be appropriate to slow down” the big-and-fast rate hikes. But in August headline inflation remained scary with the CPI surging 8.3% YoY, despite widespread Wall Street expectations for it to slow markedly. Finally QT2 hit its monthly target, with $47.3b of Treasuries and MBSs unwound! Late that month the Fed chair spoke with resolute hawkishness.
At the Fed’s annual Jackson Hole symposium, Jerome Powell gave a short speech arguing the Fed has to keep fighting inflation until the job is done. He warned that is going to cause pain to households and businesses. The FOMC’s extreme tightening on both the rates and QT fronts is intended to pinch wallets so much that consumer demand broadly slows. Fomenting a recession will take pressure off soaring prices.
September was the month QT2 was supposed to ramp to that blistering $95b-per-month terminal velocity. Unfortunately the latest Fed-balance-sheet data won’t be released until after this essay is published. But as of the 21st, the Fed’s total Treasury and MBS holdings had only shrunk $15.5b this month! I wonder why the FOMC seems to be dragging its feet on QT2. Are Fed officials worried about slaughtering stocks again?
While CPI data isn’t released until the following month so September’s wasn’t out yet, the FOMC kept on hiking with another monster 75bp one last week! The Fed officials are hellbent on hiking rates to destroy demand, which is ineffective. Low rates don’t really spawn inflation. The federal-funds rate was at zero for 7.0 years continuously before December 2015! During those 84 months the CPI averaged just +1.4% YoY.
As Milton Friedman warned in the 1960s, inflation is solely driven by money-supply growth. If the Fed is serious about killing this raging inflation unleashed by its extreme QE4 money printing, it has to reverse that. It has to run QT2 full-speed for years to unwind the majority of those $4,913b of bond monetizations. Will Fed officials find the courage to keep destroying their gross monetary excesses while stock markets burn?
They sure didn’t during QT1! But they might get religion this time around, with the CPI over the past year averaging scary 7.7%-YoY jumps. Over the last six months, that monthly average surges to +8.5% YoY. And ominously the CPI calculation methodologies have been manipulated for decades to report lower inflation than really exists. Voters hate, hate, hate inflation’s pernicious stealth tax, so politicians try to hide it.
If today’s CPI was still computed the 1970s way during the last inflation super-spikes, economists who have studied that era generally say it would be about double current headline levels! And high inflation is likely to fester until general prices either normalize with QE4’s colossal money-supply growth or enough of that liquidity is obliterated through QT2 to arrest that process. But even at $95b per month it will take a long time!
That’s seriously bearish for these stock markets directly levitated by QE4’s vast deluge of freshly-conjured dollars. Especially with valuations remaining so darned high. Entering September, those 500 elite SPX stocks still averaged near-bubble 27.2x TTM P/Es! That wasn’t much better than 31.4x just before QT1 went terminal in Q4’18. Even though that ran about half QT2’s pace, it quickly bashed the SPX 20% lower.
QT2 will almost certainly prove way more perilous for these overvalued stock markets than QT1. It is almost twice as big and Fed officials don’t have any breathing room to back off as the SPX plunges on monetary destruction. As long as inflation rages out of control punishing American voters, the FOMC will have to be seen as doing everything possible to slay it. Even if these lofty stock markets are collateral damage.
So what should investors do? Reallocate sizable fractions of their stock-heavy portfolios to gold and its miners’ stocks. Gold investment demand climbs on balance in stock bears, driving gold prices higher. The major gold stocks usually amplify gold’s gains by 2x to 3x, while smaller fundamentally-superior ones fare much better. There’s no better asset class to own as raging inflation ravages the dollar’s purchasing power.
Gold skyrocketed during the last similar inflation super-spikes in the 1970s. In the first the CPI blasted from +2.7% YoY to +12.3% over 30 months into December 1974. Gold’s monthly-average prices from trough to peak CPI months launched 196.6% higher! During the second the CPI exploded from +4.9% YoY to +14.8% in 40 months climaxing in March 1980. Gold’s monthly-average prices were a moonshot, up 322.4%!
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The bottom line is the Fed’s aggressive new quantitative-tightening campaign is greatly imperiling these lofty stock markets. They were levitated to extreme heights and dangerous bubble valuations by epic Fed QE4 money printing after the pandemic-lockdown stock panic. Starting to unwind that deluge of liquidity with QT2 will suck big capital out of stocks. That will seriously exacerbate their young bear underway.
When QT1 hit terminal velocity in late 2018, the S&P 500 plummeted nearly 20% in a single quarter. And QT2 dwarfs QT1 in every way, ramping up in a quarter the time to almost double the size! And this time around with inflation raging out of control Fed officials don’t have the luxury of capitulating to save these overvalued stock markets. They have to run QT2 full-blast until headline inflation retreats back to normal.
Adam Hamilton, CPA
September 30, 2022
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