Fed’s ‘quantitative tightening’ was supposed to sink stocks and the economy. It may be boosting them instead, analyst says.

This could potentially explain the boost that U.S. stocks have received this year, as the S&P 500
SPX,
-0.79%
has risen roughly 15% since the beginning of 2023, according to FactSet data. Although these gains have yet to offset a 19.4% drop from 2022, the worst calendar-year performance for the index since 2008.

See: The secret to stocks’ success so far in 2023? An unexpected $1 trillion liquidity boost by central banks.

The Fed has been removing some of the liquidity injected during the 2020 pandemic by implementing a program of quantitative tightening or shrinking its balance sheet either by allowing bond it holds to mature or by selling them and reducing the money supply. The Fed’s balance sheet has already declined in size from $8.5 trillion one year ago to $7.7 trillion as of Thursday.

In September, the Fed accelerated the pace of its balance-sheet unwind to $95 billion a month, with maturing Treasury bonds representing roughly two-thirds of that figure.

Meanwhile to combat high inflation in the wake of the pandemic the Fed has raised its policy interest rate steadily for the past year. In theory, higher interest rates make it more expensive for companies and consumers to borrow money, while making ultra-safe Treasury debt more attractive in comparison to risky stocks and thus slowing investment and economic growth.

But that’s not what’s happening in 2023, according to Axel.

As the Fed has taken a step back from the bond market, private investors have picked up more of the slack by buying more newly issued bonds. This has the effect of transferring more of their money from cash or bank deposits and crystallizing it into Treasurys that carry the highest interest rates since before the 2008 financial crisis.

Rather than draining money from the financial system, the result is that the public’s money shifts from one vessel to another, while boosting the payouts that savers receive.

“The key observation here is that the public spends one form of government liability to buy another. It is an asset swap. As a result, the liquidity drain doesn’t actually reduce financial assets of the public, it only changes the composition of financial assets held by the public,” he said in a note to clients shared with MarketWatch on Thursday.

While the Fed’s interest rate increases have piled pressure on vulnerable small- and midsize lenders, contributing to the collapse of Silicon Valley Bank and other U.S. banks earlier this year, savers have benefited after accepting almost no return on their cash and bond holdings for more than a decade.

There is one potential drawback for markets, however: to achieve its aims of slowing economic growth to combat inflation, the Fed may need to push interest rates even higher than it might have otherwise. It will likely need to keep them elevated for longer than markets are currently pricing as well, Axel said.

“Households aren’t losing wealth in the liquidity drain but are swapping into higher yielding government liabilities,” he said. “For the Fed, this means that QT is probably less potent in slowing demand, which implies greater risks of a higher, and higher-for-longer, Fed rate path than markets currently price.”

Another analyst made a similar claim that the Fed has been abetting the stock-market rally by relying too much on higher interest rates while not reducing the size of its balance sheet quickly enough.

“…The Fed has not tightened enough on Wall Street by using the balance sheet to reduce liquidity in the financial system. They’ve already tightened excessively on Main Street so a recession still seems inevitable to us in the second half of the year,” said Thomas Tzitzouris, head of fixed income research at Strategas, during an interview on Bloomberg TV.

According to BofA’s base-case forecast, the Fed’s effective policy interest rate will likely peak at 5.6%, which would imply two more interest rate increases. The upper band of the Fed’s target rate range currently stands at 5.25%. While Fed funds futures are pricing in rate cuts in late 2023 or early 2024. BofA’s economists expect the central bank will keep borrowing costs elevated until May 2024.