What impact will quantitative tightening have on asset prices?

Fed's quantitative tightening could end in mid-2023

>> Where will the terminal FED funds rate land?

The first is to argue that financial assets are in a "normal" position and will respond to all the usual influences like economic growth, policy rates, inflation, commodity prices, etc. as they have in the past. This may lead some investors to be bullish on asset prices because they see inflation falling sharply, growth recovering, central banks cutting rates, etc.

The second is that they might be bearish because they see deep recessions but elevated prices and much more from central banks in the way of rate hikes. But there is another school of thought that says none of this matters; that asset prices are still overinflated as a result of massive quantitative easing (QE) by central banks in the past, and that asset prices will fall regardless of policy or the macroeconomy because the QE process is being reversed.

In other words, financial assets are not in a "normal" position but still in a very abnormal position because their elevated levels are primarily due to central bank largesse that is now over.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there would be very little doubt that bouts of QE dating back to the global financial crisis of 2008 have lifted asset prices, particularly bonds. After all, this is exactly what the policy was designed to do. However, it is a mistake to believe that reversing this policy, known as quantitative tightening (QT), will result in similarly large declines in asset prices for the following reasons:

The first is that QE has worked to lift asset prices more through market expectations about future policy than the physical effect of central bank bond purchases themselves. For what has happened in the past is that a sudden adverse shock has occurred, such as the global financial crisis or the pandemic, which has spurred the start, or restarting, of QE, and, at this point, or even beforehand, market expectations and market prices have adjusted dramatically.

Hence, even if we can quantify that X amount of QE leads to a Y-sized decline in bond yields over time, the vast bulk of this decline occurs when the policy is announced, or even beforehand if the market discounts such central bank action. But while the adjustment of expectations and asset prices is very rapid when QE starts or is on the cards, it is very slow when things turn towards QT. Central banks take a long time to prepare the markets for QT (unlike QE), and hence expectations and prices seem unlikely to adjust as fast and as significantly as during QE.

A second factor in Mr. Steve Barrow’s view is that QE should be seen as a stock concept, not a flow concept. In other words, it is the stock of assets that central banks hold that is important, not the flow in and out. In theory, central bank assets should grow in line with the pace of the public’s demand for cash. That happened before the financial crisis. Every bond that a central bank owns that is above the public’s demand for cash represents excess monetary provision, even if much of this excess cash is held by banks in accounts at the central bank. QT will deplete these excesses, but these excesses will remain all the same and, as long as that’s the case, can impart a positive bias to asset prices.

>> What hinders the FED from raising rates?

A third point is that central banks are not likely to reduce their asset holdings to levels that equate to the public’s cash demand. The Fed, for one, has been very vocal that its USD8.5tr of assets won’t be reduced to anything like the USD1.5–2tr that would be consistent with public cash demand (and the pre-GFC path).

Finally, on a related point, the market seems more inclined to think about a limit  ed-time path for QT. During QE, we heard many argue that the policy was really one of QE forever, and so it might have seemed. But nobody talks about QT forever, and that should help insulate asset prices against central bank asset sales. We could go on, but the broad point that we’d make is that the central bank's adjustment of balance sheets is likely to be far more effective in moving asset prices during phases of QE than during passages of QT. That should not be surprising, as it is something that the policy was always designed to do.