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Quantitative tightening and you

Quantitative tightening is a regime change in the markets, illustrated here by military shooters and a helicopter

What is quantitative tightening? Why are bond funds falling? Should you alter your portfolio before the Bank of England further raises rates and soaring inflation sends you to the soup kitchen?

All good questions that we’re hearing from Monevator readers every day.

So let’s have a primer on what’s going on with central banks, rates, inflation, and the market.

Setting expectations

With most things in investing, every answer leads to two more questions.

Such exponential growth is great for compounding your wealth. But it’s bad for your patience and my fingertips.

So rather than go down every rabbit hole, I’ll include plenty of links to other articles.1

And we’ll put off considering what (if any) action you should take until next week.

When we’re done you still won’t like it if your portfolio falls when a central banker opens their mouth. But at least you’ll know why you’re down!

Note: there will be much talk of the US. That’s because as the engine of global markets, changes in US monetary policy typically affect everything.

What is quantitative tightening?

Quantitative tightening (QT) is a contractionary monetary policy. It’s the opposite of quantitative easing (QE).

In fact QT potentially reverses QE.

Still with me?

Okay but (a) what the flipping Henry is a ‘contractionary monetary policy’? And (b) as many of us never really understood QE, reversing it doesn’t simplify much.

So, briefly, QE involves experiments operations by central banks to lower interest rates. They do this to support economic growth and soothe stress in the financial system. The bankers’ aim is to hit their inflation target and any other policy goals.

Traditionally central banks exerted their influence by changing the base interest rate that commercial banks are charged for holding money with them.

However in the ruinous crater-strewn landscape that followed the financial crisis, central banks went unconventional.

The bankers wanted to support asset prices, tempt money into riskier securities, and encourage economic growth to ward off deflation. They’d try to do this by keeping market rates lower than they otherwise would be.

Led by the US Federal Reserve (the Fed), central banks purchased higher-yielding assets from commercial banks in exchange for more liquid shorter-term paper. (Read Cullen Roche’s QE series for the mechanics.)

The net result was higher prices for safer assets and lower yields across the spectrum.

For example, the graphic below shows the decline in the all-important ten-year bond yield in the heyday of pre-pandemic QE.

Most economists (though not all) would agree this descent was at least partly due to QE:

Source: Vanguard

Other mooted impacts of QE – such as egging on reckless speculation or juicing the money supply – are more hotly debated.

For instance the Bank of England found no evidence QE boosted lending in the real economy. (Although some might say: “it would say that wouldn’t it.”)

The consequences of quantitative tightening

Quantitative tightening should be the opposite of QE. Central banks will wind down their purchases of assets (and eventually maybe sell them). They will also raise their base rate.

This should reduce demand for assets like government bonds compared to cash and short-term paper, and hence increase yields as bonds are sold off. (When bond prices fall, yields rise).

You’d expect this to happen until bond yields reach a level that tempts enough buyers back into them.

And indeed this dance has already happened. Without the US Federal Reserve yet raising interest rates or halting asset purchases, yields have been shifting across the curve in anticipation:

Source: GuruFocus

Expectations are everything in financial markets. Yields have risen as traders try to anticipate where rates and inflation will be in one or two years from now and beyond. It’s happened in all major markets.

That is why your bond funds are down.

Markets now expect slightly more than half-a-dozen US rate rises in this cycle, starting in March.

Meanwhile in the UK bank rate is expected to be above 1% by the end of 2022, peaking in 2023 at around 1.5%.

Why do quantitative tightening?

Okay, but if QE made money cheap and it supported economic growth, why stop? Who doesn’t like free money and a booming economy?

Well, central bankers for a start. History suggests too much of a good thing can cause the economy to overheat.

At best that could stoke even higher inflation, which would then have to be choked off with more rate rises – and perhaps a deeper recession – compared to if central bankers had acted earlier

At worst too much cheap money could lead to dumb investment decisions, credit bubbles, and another financial crisis.

(Actually, history again reminds us of worse still. Folks who end up moving their near-worthless savings around in wheelbarrows get politically uppity. Think gunshots in the streets uppity.)

Central bankers would therefore like to return conditions to normal in their noble pursuit of price stability. (And to avoid a revolution).

Once conditions are ‘normalized’, they can go back to simply raising base rates – and their eyebrows – to influence the economy.

(They’d also probably like to get back some of their firepower so they have more ammunition to respond in the next crisis.)

Some doubt complete normalization is achievable anytime soon, due to the sheer scale of QE. But it’s the aspiration.

However there’s an even bigger reason to start quantitative tightening ASAP – which is that inflation is missing its target by about the same margin as I missed out on playing for Man United.

Inflation is running at 6-8% in the US and Europe. And unemployment is very low.

It’s hard to justify rock-bottom rates when inflation is going through the roof.

Quantitative tightening and your bond funds

With all this going on, it’s clear why the mere talk of quantitative tightening has roiled markets – and your portfolio.

Higher rates across the yield curve come about from falling bond prices, as investors reshuffle their holdings according to their expectations for central bank interest rate hikes and any reversal of asset purchases, as well as their forecasts for inflation.

  • At the ‘short end’, those government bonds that will mature over the next year or two have sold off mostly in anticipation of imminent central bank rate rises.
  • The further out you go towards the ‘long end’, however, the more inflation expectations and the prospects for economic growth drive bond prices/yields (by influencing the much more uncertain expectations for interest rate levels that will prevail many years hence).

Short-dated US Treasuries have seen their yields rise faster than long-dated bonds. Short-dated bonds compete with cash in the bank, where traders are very sure interest rates will soon be much higher.

In addition, traders might be betting that the more central banks tighten now, the greater the long-term impact on market interest rates and inflation.

Hence expectations for more rate rises – and sooner – that have emerged in 2022 (driven by higher than expected inflation and arguably lower unemployment) may imply a need for fewer rate rises further out.

Or maybe the market fears a policy error?

This is all a balancing act for central bankers. If they go too heavy too soon with quantitative tightening, they could cause a recession.

Expectations of a recession may be signaled by the yield curve inverting – a situation where long-dated bonds yield less than short-dated ones. (Unusual, due to the additional term premium that’s normally demanded by investors in longer-term bonds).

The curve is already flattening, as short-term yields have risen by more than long-term yields:

Source: Mish Talk

We may well discover a recession is an inevitable price to pay for the easy money conditions (and asset price rises) of the past decade.

But I don’t think it’s a policy goal.

Higher rates and inflation affect equity valuations

Broadly speaking, equity valuations also turn on the cost of money (interest rates) and inflation.

  • With higher inflation, the value of future earnings in terms of today’s money is lower.
  • With higher rates, investors see safer returns from cash and bonds as more attractive than before. So again, they’ll value uncertain future earnings less highly.

We can expect quantitative tightening to depress valuations for pretty much all asset classes.

However some investments (such as miners and energy shares right now) may enjoy an off-setting boost, as high inflation makes their near-term high earnings more attractive.

With a lot of fits, starts, bumps, and reversals, the same repricing and reshuffling shenanigans we’re seeing in bonds will therefore play out across the risk/reward spectrum of all assets.

Investors are now re-evaluating equities, property, and even the likes of gold.

As I noted, companies’ shares are mostly valued on their future earnings power – discounted by expectations for interest rates and inflation.

The more that a company’s earnings will come in the far future, the more higher yields and inflation expectations will impact – in theory – its present value.

When interest rates are at zero and inflation is low, the value put on future earnings can be very high indeed. Cash is trash (in that it earns you nothing) and low inflation expectations means distant earnings will still be very attractive in terms of today’s money.

All that changes with quantitative tightening and with higher inflation, however.

Investors aren’t willing to pay so much for a company that won’t be profitable until 2030 if they think that by then the spending power of cash will have fallen 25% in real terms and they might have earned 3% a year in the bank on the way.

Hence the ‘multiple’ investors put on the company’s earnings will go down.

Played out across all companies, this re-rating can cause a market decline.

The ups and downs of go-go stocks

In practice so-called growth shares have been hit much more than value shares.

Investors had slapped very high multiples on growth companies’ future earnings – and then ratcheted them even higher on the back of temporary stay-at-home economics. They’ve now reined that in.

Of course shares represent businesses, and their individual fortunes will depend mostly on the success of their operations.

But tightening monetary conditions can have a direct impact here, too.

For example, banks may reduce lending, making it harder to (re)finance and to borrow to grow.

Or consumers may decide to save more and so reduce their spending, hurting sales.

It’s all connected

A big shift in the outlook for rates and inflation ultimately changes the relative attractiveness of all assets.

Investors now even view something like gold – which has no earnings – differently.

When your cash earns you nothing in the bank, why not own gold?

Conversely when cash is paying say 2%, why pay to hold gold that earns nothing?

Remember: a goal of QE was to push money to accept riskier returns.

All things being equal, we can therefore expect quantitative tightening to do the opposite. Investors will retrench. More investors will eventually see attractive returns available again from bonds, thanks to higher yields following price declines. Some money that shifted into shares in a desperate hunt for yield will go back to fixed income.

This is all why – besides their eternal effort to sound sexier than accountants – City types call the shift to quantitative tightening a regime change.

Thankfully the CIA need topple no banana republics to get us to this new financial world order.

But if the 40-year decline in interest rates really is over, we can still expect some fireworks.

The turning of the screw

We now know what quantitative tightening is, and why it’s happening.

But to return to where we started, what does it mean for your portfolio?

Well, it sure looks like a recipe for more volatility, lower stock markets than otherwise, and – gasp – falling bond prices.

But before you sell everything and cower in a cash savings account (where you’ll be losing 6% a year in real terms) I have a menagerie of caveats.

We’ll get into those next week.

  1. Fewer people seem to follow links nowadays. What a waste of hypertext! []
{ 14 comments… add one }
  • 1 Barn Owl February 15, 2022, 12:04 am

    Rising inflation means cash will lose value in real terms.
    The fix is raising interest rates, which as the article shows means bonds and equities lose value.
    FvL says that leverage is a good idea in inflationary times because debt will inflate away over time. But we need the borrowed money to be invested in something that keeps up with inflation.

    I am looking forwards to the “what to do about it” article! I think it will have to be a bit more quantitative rather than just directional?

  • 2 xxd09 February 15, 2022, 12:09 am

    Tin hats everyone-again!

  • 3 Andrew February 15, 2022, 12:50 am

    My greatest fear is interest rates will rise and house prices will also continue to defy gravity.

    The whole thing is depressing. People living in modest 3 bedroom homes near London are gaining more home equity every month than your average UK worker takes home in salary.

    Something has to give.

  • 4 The Investor February 15, 2022, 1:11 am

    @Barn Owl — You write:

    Rising inflation means cash will lose value in real terms.

    This is absolutely true, but what I think people forget is that most other assets also lose money in real terms, too — unless their price goes up enough or they kick out sufficient income to compensate. 😉

    I know you realize this and it’s obvious once stated, but I’m not making an entirely glib point.

    It could be that sucking it up with a slug of cash should very much be part of the mix right now. It could even be that cash is the best asset class to own at the moment. 🙂 It’s been doing pretty well versus the Nasdaq, for example, on a one-year view on a risk-adjusted basis. (It’s lagging but with zero volatility!) Cash is also beating a typical basket of gilts on a 12-month view too. In both real and nominal terms…

    I don’t think the follow-up will be especially quantitative, depending on exactly what you mean by that. Everyone’s portfolios, risk tolerances, tax situation, and circumstances are different. As for future asset class returns and volatility — they’re unknown.

    @xxd09 — Who knows! It’s good we have an interesting hobby though, eh? 😉

  • 5 Meany February 15, 2022, 2:12 am

    Re QT depressing equity valuations, is it possible to put a rule of thumb
    number on that?
    e.g. if VAGP drops 2.87% (with ALL of that drop caused by the shift in the rates/QE situation), we should expect an (X*2.87)% drop in VWRL; what is X?

    They say Russia have dumped billions of dollars to buy gold last few years. Maybe the gold price depends mostly on whether Russia prefers to hoard or
    deploy it, for a while?

  • 6 ZXSpectrum48k February 15, 2022, 11:00 am

    @TI. Couple of small points. The yield curve isn’t normally upward sloping due to time value of money but due to the assumption of term premia – the longer you lock away your money, the more compensation you need for interest rate volatility. Given interest rates are assumed to follow a Brownian process, that term premia will be a function of the square root of time. Hence the “parabolic” y^2=x form of a “textbook” yield curve.

    Safe to say this is all a big assumption. The curve is fundamentally flatter in the last two decades due to the impact of inflation targetting. It should (and did) reduce term premia.

    Second point is that journos and economist types seem to get very upset about flat or inverted spot curves (2v10y etc). This is silly. If the Fed starts hiking in Mar, then they can’t hike forever and will cut at some point in the future. So the curve has to invert in forward space somewhere. The spot curve (2v10y etc) is just a geometric compounding of those forward rates. Whether it’s positively sloped or inverted is a mechanical function of that!

    The curve is already inverted in forward space. The market’s assumption is that rates peak in late 23, drop modestly over 24/25, and then term premia dominates causing the curve to rise modestly higher again out to 30 years. Looks pretty sensible and nothing very worrying. Recessions follows expansions, cutting cycles follow hiking cycles. What could be more natural?

  • 7 JP February 15, 2022, 11:56 am

    So pleased you are covering this topic. Ive been wondering how all this might pan out for markets in the short and medium term and its great to have the basic workings set out. Looking forward to the next item on this!

  • 8 The Investor February 15, 2022, 12:24 pm

    @ZXSpectrum48K — Thanks for the feedback. Yes, sloppy wording (and rusty thinking!) on my part indeed, which I’ve now corrected. It’s fair to say that @TA and I always write about bonds rather gingerly, knowing you’ll probably be reading later… (That’s no bad thing — always learning!)

    @Meany — I think some people would claim to be able to do that, but I am not one of them! You could do it by looking at historical correlations (which may be inherently just noise, or reflective of different circumstances of history) or you could try to break down and model the components of the return from each asset class (e.g. interest rate and inflation compensation, risk around both, productivity growth, underlying economic growth — I am just throwing out potentials here off the top of my head with no reading or precision!) and then rebuild based on your expectations. A quant type might look at the beta (volatility) of both asset classes, and then apply leverage as required to get a (supposedly) more robust return (a risk parity approach).

    @JP — Glad you’re enjoying it. Please be aware I’m extremely humble as to my knowledge about what will happen from this! I do think though we can have a sort of scaffolding of thinking, that tends away from extremes (The ‘sell all bonds’ / ‘giant ponzi scheme in the stock market’ type approaches) and enables us to move forward with a ‘probably roughly right’ portfolio. In reality, over the short to medium term events and sentiment will drown out any precision anyway.

    @Andrew — Hopefully rate rises will curb house price inflation but not crash house prices. Which sadly would mean a long wait for houses to look anything like as affordable as they once did. I used to get annoyed before I owned my own home when old hands would say that sort of thing but (a) I guess I’m now biased and self-interested too despite any efforts at compensating for that and (b) more pertinently, the UK is so in hock to the housing market that a serious correction would surely be economically devastating. Given we’ve already hobbled our economy with a certain political decision in recent years, I’d rather we avoided another self-inflicted mega-whack.

  • 9 Miner2049er February 15, 2022, 5:23 pm

    Hell bells, too much info for my brain to process, will tell the Mrs tonight retirement is next year November not this year, one more year it is then.

  • 10 Thomas February 15, 2022, 10:22 pm

    Awesome summary of what is going on in the markets. I personally think that a recession is probably a price that we will have to pay. The question will then be whether the central banks let it run its natural course or step in. If they step in with more liquidity then I guess the regime change will have to wait a few more years. I watch with interest but the uncertainty is hard to handle.

  • 11 Pedro February 16, 2022, 4:54 pm

    Difficult to know what (if anything) to do really; gut and passive leanings put me at 90% “ignore everything and carry on”, especially with a likely 15yr horizon still. That remaining 10% is still pulling me to put remaining cash somewhere “more sensible” before it gets inflated away.

    I suppose there’s always spread betting and NFTs… 😉

  • 12 Robert February 16, 2022, 5:15 pm

    This is exactly what I was looking for when I looked at my bond funds and saw a -7.59% drag on my Vanguard U.K. Government Bond Index Fund. Thank you for sharing and for explaining. More reading required for sure.

  • 13 Jake March 3, 2022, 3:57 pm

    Out of interest – and with a layman’s grasp of the matter – is the Vanguard U.K. Government Bond Index Fund a sensible choice of fund for a low-risk portfolio? Would it make sense to have this as 50% of a low-risk portfolio (the aim of the portfolio being to provide security in retirement)? Or should this be reconsidered? Thoughts welcome (I won’t treat them as advice!)

  • 14 Ben September 1, 2022, 8:49 pm

    This article misses a key point about QE, which is how central banks obtain the money used for asset purchases – they create it (https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy). Likewise quantitative tightening involves the digital destruction of money received when bond mature or are sold.

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