Fed Caves On Tightenings

At mid-December’s Federal Open Market Committee meeting, Fed officials began discussing quantitative tightening.  Effectively selling previously-monetized bonds to unwind quantitative-easing money printing, this revelation from the minutes rattled markets in early January.  But hawkish-jawboning talk is cheap, as the Fed’s last QT campaign proved.  It was prematurely abandoned after stock markets threatened a bear.

The minutes from the FOMC’s December 15th meeting were released three weeks later like usual on January 5th.  They chronicled an uber-hawkish assembly, led by doubling the pace of slowing QE4’s epic money printing.  That turbo-taper was joined by Fed officials’ individual rate-hike outlooks tripling from two rate increases across 2022 and 2023 to fully six!  Such a stark tightening pivot should’ve left no hawkish surprises.

But the minutes still revealed a huge one, these Fed officials overwhelmingly supported launching QT soon after the FOMC’s initial rate hike in this next cycle.  “Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.”  Balance-sheet runoff means not replacing QE-purchased bonds when they mature.

While this type of QT is milder than selling bonds outright to speed up this essential monetary-destruction process, Fed officials expected an earlier-and-faster runoff.  “...participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience.”  Traders are already pricing in a 100% chance that initial hike happens in mid-March.

Those minutes continued, “Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”  The Fed’s only other QT experience began in Q4’17, starting at $10b monthly and ramping by another $10b each quarter until it hit its $50b-per-month terminal velocity in Q4’18.  Traders took the Fed at its hawkish word, slamming markets.

The benchmark US S&P 500 stock index (SPX) plunged a sharp 1.9% into close on those QT minutes.  Gold dropped from $1,825 just before their release to an $1,811 close, then got hammered another 1.2% lower the next day.  Bitcoin cratered then too, plummeting 6.1% on close.  So traders apparently believed the FOMC is really on the verge of starting QT soon and running it hard.  But history argues the Fed will fold.

Hawkish jawboning is the main weapon in central bankers’ tightening arsenal.  It is far easier to talk about raising rates and unwinding monetized bonds than actually doing it!  And nothing emboldens Fed officials to threaten tightening more than record-high stock markets.  When that mid-December FOMC meeting was underway, the SPX was just a couple points off its all-time-record close from a few trading days earlier.

Lofty stock markets give Fed officials courage to start hiking rates and selling monetized bonds.  But as those very tightenings increasingly weigh on stock prices, the FOMC’s policies are blamed.  So Fed officials soon capitulate under that intense pressure, prematurely ending tightening cycles then often quickly resuming easing.  These abrupt turn-one-eights when markets call the Fed’s bluff have shredded its credibility.

Major stock-market selloffs threatening bear-market territory down 20%+ risk spawning recessions due to the negative wealth effect.  The worse stock markets are faring, the worse Americans feel whether they are investors or not.  So they pull in their horns on spending, which can cascade in a vicious circle.  Lower demand hits corporate earnings, forcing layoffs that further erode spending slowing the overall economy.

Stock-market selloffs have pressured the FOMC into surrendering on so many tightenings that traders coined the term “Fed Put” for these capitulations.  Once SPX drawdowns grow large enough, Fed officials lose the stomach to keep tightening.  So traders need to take both hawkish jawboning and newly-underway tightening cycles with a grain of salt.  They almost never run as long as Fed officials imply up front.

Case in point is the FOMC’s last rate-hike cycle and only historical attempt at quantitative tightening.  Both were prematurely abandoned after they hammered the SPX to the verge of bear-market-dom.  Like Fed officials are threatening now, the rate hikes started before QT.  That twelfth Fed-rate-hike cycle of this modern era since 1971 was launched in December 2015 after 7.0 years running a zero-interest-rate policy.

Every-other FOMC meeting is accompanied by a so-called dot plot, a collation of individual Fed officials’ unofficial forecasts for future federal-funds-rate levels.  The latest December 2021 dot plot is where this outlook tripled to six hikes through 2022 and 2023.  Back in December 2015 with the Fed’s first rate hike in 9.5 years, that dot plot forecast four more hikes in 2016.  But only one happened, fully one year later.

The FOMC put that hiking cycle on hold because the SPX dropped 10.5% in just 1.9 months following that maiden rate increase.  Fed officials didn’t resume that tightening until December 2016 after a long series of new all-time-record closes in that benchmark stock index.  That ushered in the 2017-to-2019 span rendered in this chart, which traders today must remember when evaluating the FOMC’s credibility.

The S&P 500 is superimposed over the total assets on the Fed’s balance sheet, revealing the only other quantitative-tightening episode in history.  Individual FFR hikes and cuts are noted, as are changes in the pace of both QT bond selling and quantitative-easing bond monetizations.  The Fed Put is very real, top Fed officials cave soon after tightening cycles fuel major stock selloffs.  This next one won’t prove any different.

The SPX’s parade of record closes resumed with a vengeance in November 2016 after Trump’s surprise election victory.  That Republican sweep included control of the Senate and House, leaving traders ecstatic on the high likelihood of big tax cuts coming soon.  That incredible taxphoria catapulted the stock markets almost straight higher in 2017, making it easy for the FOMC to resume hiking and finally launch QT.

The FOMC hiked a third time in mid-March that year, followed by a fourth in mid-June.  Back then only every-other FOMC meeting was followed by the chair’s press conferences, so that’s when policy changes were mostly done.  If the stock markets tanked on the 2:00pm FOMC statements, the Fed chair could wax dovish at the 2:30pm press conferences to moderate that impact.  So rate hikes were on a quarterly cadence.

The FOMC took a break from hiking at its September 2017 meeting to launch quantitative tightening to start shrinking the Fed’s bloated balance sheet.  Starting with October 2008’s brutal stock panic, QE1, QE2, and QE3 bond monetizations had ballooned the Fed’s assets by $3,625b over 6.7 years!  They had peaked way back in January 2015, but never contracted more than 1.5% before that September 2017 meeting.

Since QT had never before been tried to unwind QE, Fed officials were worried about how markets would take it.  So they decided to gradually phase in QT mechanically, starting at a trivial $10b-per-month pace in Q4’17.  That would slowly ratchet up an additional $10b monthly each quarter until reaching its terminal pace in Q4’18.  Even after hitting that $50b a month, just unwinding half of that QE would take 30 more months!

I wrote a popular essay that very week arguing that Fed QT was this stock bull’s death knell.  An SPX that had been directly-QE-levitated for years couldn’t persist when those big monetary inflows reversed hard into outflows.  But with QT starting small and traders infatuated by the still-nearing huge Republican tax cuts, the SPX initially kept blasting higher.  That big tax-cut bill finally passed Congress in late December 2017.

With the stock markets powering to an endless series of new record closes, it was easy for the FOMC to hike a fifth time in mid-December 2017.  Fed officials didn’t even talk about QT, which was on autopilot ratcheting up at quarter-ends.  That taxphoria stock-market surge ultimately peaked in late January 2018, followed by a blitzkrieg 10.2% SPX plunge.  But luckily for the FOMC, the SPX bounced into its next meeting.

So Fed officials hiked their FFR for the sixth time in that cycle in late March, which was soon followed by the quarter-end automatic QT increase to $30b per month.  Interestingly a neutral dot plot coming with that rate-hiking FOMC meeting helped turn the stock markets around.  Traders feared Fed officials would forecast four total hikes in 2018, but their collective outlook remained at three which was considered dovish.

At the FOMC’s next live meeting followed by a press conference in mid-June, the seventh hike was executed.  That was expected, but the dots shifted back to hawkish forecasting four hikes that year.  That hawkish surprise fueled a sharp-but-short SPX pullback.  As QT continued mechanically ramping up to $40b per month of effective monetized-bond sales, the SPX resumed powering to more new all-time-record highs.

The FOMC hiked an eighth time at its late-September meeting, and the dot plot stayed stable predicting four hikes that year along with three more in 2019.  As planned, quantitative tightening accelerated to its terminal velocity of $50b per month entering Q4’18.  After a year of Fed officials rarely mentioning QT and traders largely ignoring it, the latter finally started worrying about balance-sheet shrinkage’s impact on stocks.

Interestingly the fairly-new Fed chair Jerome Powell ignited that quarter’s first SPX plunge.  He had just assumed that position in early February, and wasn’t worried about what he said with stock-market record highs.  At a speech he flipped on the hawkish afterburners, saying after eight hikes the FFR was still easy.  He declared hiking could continue past the neutral point, which he warned was still “a long way” away!

With $50b per month of QE liquidity being withdrawn and the Fed chair himself arguing for even more rate hikes, the SPX fell 12.7% between the FOMC’s late-September and mid-December meetings.  About a quarter of that total drop happened in the couple weeks before that latter FOMC decision.  Much to Fed officials’ credit, they didn’t cave that time with the SPX in correction territory.  The ninth hike was still done.

With the SPX down hard, traders still expected Fed officials to throw them a bone in the dots.  Those did moderate, with three more hikes implied instead of the four from the previous dot plot a quarter earlier.  But traders were looking for three hikes to be cut from 2019 instead of just one.  Powell tried to calm them with a dovish press conference, but when asked about $50b-per-month QT he said it was “on automatic pilot”.

That unleashed a temper tantrum of furious selling, ultimately hammering the SPX another 7.7% lower in just four trading days!  That extended its total selloff to 19.8% in just 3.1 months, just a hair away from the 20%+ new-bear threshold.  Stock traders had finally slammed through enough heavy selling to trigger that infamous Fed Put.  The political pressure on the FOMC soared as Trump’s Treasury secretary attacked the Fed.

After plummeting to super-oversold levels, the SPX bounced hard into early 2019.  That rally stalled out before late January’s FOMC meeting, where the Fed released an entirely separate statement on QT.  It declared the FOMC was “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”  The Fed capitulated on QT, it was no longer automatic!

The SPX kept rocketing higher on that $50b-per-month terminal-velocity QT being thrust on the chopping block.  Then the FOMC totally surrendered on both rate hikes and QT at its next meeting in late March.  Not only did the Fed not hike, but Fed officials’ dot-plot FFR outlook was slashed to zero hikes in 2019.  Even more remarkably, the FOMC declared QT would be quickly tapered to be fully-eliminated by that September!

That was ridiculously-premature, a stunning show of cowardice.  That would cap QT at just $825b, which would only unwind 22.8% of that enormous $3,625b of Fed QE over 6.7 years.  When QT was originally announced just 18 months earlier, Wall Street Fed whisperers with inside tracks on Fed officials’ thinking were forecasting a half-unwind of QE1, QE2, and QE3.  Instead QT would end up being well under a quarter.

Realize the Fed’s last rate-hike cycle, as well as its first-ever quantitative-tightening campaign, were torpedoed by a mere 20%ish drop in the US stock markets!  Such baby-bear declines aren’t even big, as real bears tend to maul stock prices in half.  The SPX collapsed 49.1% in 2.6 years into October 2002, and 56.8% over 1.4 years into March 2009.  Fed officials are utterly terrified of being blamed for stock bears.

Maybe they genuinely fear negative-wealth-effect-driven recessions or depressions.  Maybe they hate the political firestorm Fed tightenings generate when the SPX is plunging.  Maybe they know the next bear will be far worse than normal, after years of their QE artificially levitating stock markets.  Maybe they fear their own stock portfolios being cut in half.  Whatever the reasons, these guys will not tolerate stock bears.

And it’s not enough to just prematurely halt rate hikes and balance-sheet runoffs.  After Fed tightenings drive near-bear SPX selloffs, the FOMC lurches the other way towards extreme easing.  When the SPX started rolling over again in mid-2019, Powell started talking rate cuts.  Then even though the FOMC only had room to cut nine times before returning to zero, it squandered three of those in the second half of that year.

Those came in late July, mid-September, and late October when the S&P 500 remained at or near all-time-record highs!  Three cuts in three months with no justification whatsoever.  But the real kicker was the FOMC radically capitulating and launching QE4 in mid-October between FOMC meetings!  Even after QT was prematurely abandoned, QE4 was declared at $60b per month with the SPX near record highs.

Yes there were dislocations in the repurchase-agreement markets then, but the Fed had already rushed in to rescue them with temporary emergency repo ops.  There was no need to reverse rate hikes with unnecessary cuts, and no reason to quickly reverse that little QT progress with massive new QE.  Make no mistake, Fed officials fold like cheap suitcases when their tightenings drive near-bear stock-market selloffs!

Their threatened new rate-hike cycle and new quantitative-tightening campaign looming this year won’t prove any different.  These guys will talk tough when stock markets remain near record highs so traders don’t care.  Their hawkish jawboning will sound bold and aggressive.  The FOMC will even start hiking and maybe even dabble in QT as long as stock markets cooperate.  But sooner or later the SPX will roll over.

Fed officials will feign nonchalance as that Fed-tightening-driven selloff crosses 5% and even 10%.  They will declare the US economy strong, and normalization through higher rates and monetized-bond runoffs healthy.  But as the SPX knifes below 15% and approaches that 20% new-bear threshold, these guys will be sweating bullets.  They will again fall all over themselves Fed Putting, stopping tightening to restart easing.

And the stock-market risks are way higher this time around than that last time.  Heading into December 2015 when the FOMC launched that last rate-hike cycle, the elite SPX stocks averaged trailing-twelve-month price-to-earnings ratios of 25.8x.  Going into September 2017 when QT was birthed, that climbed to 28.1x.  Expensive stock markets were only just hitting dangerous bubble territory starting at 28x earnings.

Remember QE1, QE2, and QE3 totaled $3,625b over 6.7 years.  QE4, which was supercharged to crazy extremes after March 2020’s pandemic-lockdown stock panic, is currently up to $4,709b over just 1.9 years!  It still has a little to grow yet before its tapering is finished in March.  That radically-unprecedented deluge of epic Fed money printing left the elite SPX stocks trading at average TTM P/Es of 33.6x entering January!

It is certainly no coincidence the S&P 500’s massive 114.4% gain at best since that latest stock panic is nearly identical to the Fed balance sheet’s 113.2% mushrooming in that same span!  These stock-market levels are totally-fake, QE4-levitated.  So if the FOMC actually finds the courage to ramp this next QT to significant levels, these stock markets are in for a world of hurt.  The SPX could plunge 20%ish within months!

So all Fed officials’ hawkish jawboning in the last few months is just cheap talk.  Action is all that matters, and the FOMC has a long sorry track record of fully surrendering tightenings when stock markets fall far enough to trigger that Fed Put.  2022’s threatened rate-hike cycle and QT balance-sheet runoff won’t last any longer than stock markets cooperate.  So traders shouldn’t fear these likely-short-lived tightenings.

Gold-futures speculators in particular are paranoid about Fed rate hikes, which is supremely-irrational.  Fed tightenings force stock markets lower, boosting gold investment demand.  During the twelve Fed-rate-hike cycles since 1971 including that last one, gold averaged 26.1% absolute gains during their exact spans.  In the seven where gold rallied, its average gains were 54.7%!  In the other five it averaged 13.9% losses.

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The bottom line is the Fed caved on its last quantitative-tightening attempt, abandoning it years early.  Once that tightening forced stock markets to the verge of a new bear, the FOMC lost all courage to keep normalizing.  The Fed reversed course abruptly to aggressive new easings.  Fed officials talk a big game when stock markets are high, hawkishly jawboning away.  But their threatened actions never live up to that.

With the SPX near record highs in recent months, Fed officials are boldly proclaiming an imminent rate-hike cycle and new QT.  While the FOMC will start those tightenings, they will only last while stock markets cooperate.  That likely won’t be long with valuations forced deep into dangerous bubble territory by the Fed’s epic QE4 money printing.  These coming tightenings will be quickly abandoned when stocks plunge.

Adam Hamilton, CPA

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