Will the Fed’s Pivot to QE Lift Markets? | Presented by CME Group

Key Concepts

• Quantitative Tightening (QT): The Federal Reserve allowing its owned bonds to mature and roll off its balance sheet, thereby reducing its holdings. This tightens monetary conditions.
• Quantitative Easing (QE): The Federal Reserve actively buying bonds, typically US Treasury bonds, to increase its holdings. This eases monetary conditions.
• Monetary Conditions: The overall availability and cost of money and credit in an economy.
• Bond Yields: The return an investor realizes on a bond. When bond prices rise, yields fall, and vice versa.
• Riskier Assets: Investments with a higher potential for loss but also a higher potential for return, such as stocks.
• Inflation: A general increase in prices and fall in the purchasing value of money.
• National Debt: The total amount of money that a country's government has borrowed.
• Deficits: The amount by which a government's spending exceeds its revenue in a given period.
• "Don't Fight the Fed": An adage suggesting that investors should align their strategies with the Federal Reserve's actions, as the Fed's influence on markets is significant.

Committee Decision on Securities Holdings

The committee has decided to conclude the reduction of its aggregate securities holdings as of December 1.

Announcement of QE and End of QT

At the October 29th FOMC meeting, Fed Chair Jerome Powell officially announced the end of quantitative tightening (QT) and the initiation of a new program of reinvesting in more US Treasury bonds, which is quantitative easing (QE).

Explanation of QT and QE

• QT: The Federal Reserve allows bonds it owns to mature and not be replaced, leading to a reduction in its balance sheet. This action tightens monetary conditions.
• QE: The Federal Reserve begins purchasing bonds again, increasing its balance sheet. This action eases monetary conditions.

Purpose and Theoretical Impact of QE

The primary purpose of QE is to lower bond yields. The Fed acts as the "buyer of last resort," meaning it is a consistent and significant purchaser of bonds. Theoretically, this increased demand should:

• Push bond prices higher.
• Consequently, push bond yields lower.
• Encourage investors to move into riskier assets, such as US stocks, in search of higher returns.

Observed Market Reaction to QE Announcement

The market reaction to the QE announcement has shown a mixed outcome:

• Equity Markets: Seemingly liked the news, suggesting a move towards riskier assets.
• 10-Year Yields: Did not go lower as theoretically expected. Instead, they rose marginally.

Potential Factors Influencing Bond Market Reaction

Several factors could explain why 10-year yields rose instead of falling:

1. Inflation Expectations: Bond investors might perceive that the Fed's move to QE, combined with potential future reductions in short-term interest rates, could spark inflation. If inflation is expected, holding bonds becomes less attractive because the fixed interest payments will be worth less in real terms. This perception could lead bondholders to sell, counterbalancing the Fed's buying activity.
2. Treasury Debt Issuance: The U.S. Treasury is expected to issue a massive amount of bonds in the coming quarters to finance the growing national debt and deficits. This substantial supply of new bonds could overwhelm the demand created by the Fed's QE program, putting upward pressure on yields.

The "Don't Fight the Fed" Adage in Context

The traditional financial adage, "Don't fight the Fed," suggests that investors benefit from buying what the Fed is buying and selling what the Fed is selling. However, the current market reaction indicates that this adage may not be holding true at this particular moment, due to the significant other concerns present in the market.

Conclusion/Synthesis

The Federal Reserve has transitioned from quantitative tightening (QT) to quantitative easing (QE), a move intended to lower bond yields and encourage investment in riskier assets. While equity markets have responded positively, the expected decline in 10-year bond yields has not materialized, with yields actually rising marginally. This divergence is likely attributable to concerns about potential inflation driven by the Fed's actions and the anticipated surge in Treasury bond issuance to manage the national debt. Consequently, the historical principle of "Don't fight the Fed" appears to be less influential in the current market environment, which is shaped by these overriding economic considerations.