US stock market performance and quantitative tightening: Explained – The Financial Express

The Financial Express
By Deepak Singh
Earlier this year, the US Federal Reserve decided to take some hard measures in order to control inflation. How has it impacted the US markets?
During the pandemic, the Federal Reserve – in an effort to protect the US economy and ensure the smooth functioning of the markets, had implemented interest rate cuts and purchased treasuries and securities. By March 2022, it held assets worth almost $9 trillion.
While the post-COVID US economy bounced back quickly, it came with a very sharp rise in inflation. In an effort to arrest the runaway inflation, the Fed raised the interest rate earlier this year. It also indicated that quantitative tightening (QT) measures would be adopted to reduce the asset size.
The expected interest rate hike helped in managing liquidity. Liquidity simply means the ‘amount of money in the system which can be spent’. An increase in the interest rate makes borrowing costlier – which in turn curtails spending. For the Fed, however, the aggressive interest rate hike was only one portion of their strategy to manage inflation. Quantitative tightening would form the other portion.
Quantitative tightening is a monetary policy tool used by central banks to reduce liquidity in the economy. Usually, this is done by selling government bonds or allowing the government bonds to mature.
To explain further, the Fed holds government bonds which allows them to recover their principal upon maturity. When these bonds mature, the Fed is able to recover its principal. During quantitative tightening, the Fed will simply allow these bonds to ‘run off’ – in other words, it will not reinvest the money – thereby, reducing the balance sheet size.
Alternatively, the Fed can also choose to sell off these bonds in the market. This will cause a fall in demand for the government bonds and push up the interest rates.
Eventually, these measures are likely to bring down the inflation rate. It will also encourage savings as opposed to spending – further reducing the liquidity.
Also Read: How important are US Fed rate hike decisions for investors to keep an eye on?
Curtailing liquidity and increasing interest rates disincentivizes companies from borrowing and investing in growth. Such measures, therefore, cause risk to financial stability and adversely affect equities. This situation, however, is not sustainable in the long run. The current tightening measures have not delivered results at the desired speed. Since April, the QT measures have netted only $206 billion. Therefore, the QT measures are expected to continue well into 2023 and early 2024. This may cause a further fall in US equities.
Also Read: US Stock market postpones the Santa Claus rally after central banks warn of more rate hikes
Looking back, the markets have bottomed out 6 to 9 months before the end of any recession. Given the slowdown in the US, emerging markets also become an attractive alternative for investments. Historically, the emerging markets have done well whenever the US markets goes through a struggle. Recent events and global trends may also favor these emerging markets. From an investor’s perspective, this could be an opportune time to invest in shares of companies with strong fundamentals. For an investor with long term goals in mind, such a scenario presents the best buying opportunities.
(Author is Chief Business Officer at Reliance Securities)
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