RIP Bull Market, QT is Here

Back in 2018, I expected a big bear move. I fortuitously posted this piece the weekend before the Volmageddon (though did not expect it). End of Rally or End of Bull: Is It 1987, 1994, 1997, 1998, 2000, 2007 or 2014?.

I expected a bear move in 2022 too, before knowing what type of QT, if any, was coming. See: The Bear Pill Adding QT to this backdrop only intensifies the bearish outlook for stocks.

QT was a major drive of Volmageddon and the autumn swoon in stocks. My thesis back then (I was far from alone in seeing this) was that the market tracked the Fed's balance sheet. The percentage change in both was very similar from 2008 to 2014. When QEs ended, there were sell-offs or sideways moves in stocks. A hypothesis was proposed. 

WALCL up (the FRED code for the balance sheet), SPY up. 

WALCL flat, SPY flat (with down moves and recoveries). 

WALCL down, SPY down.

QE also suppresses volatility as Federal Reserve Chairman Powell, then Vice Chairman, explained at the October 2012 meeting:

MR. POWELL. I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.

First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman.

Now let's go to the charts.

First is WALCL and SPY.

Here is WALCL and SPY from December 2008 on, as a performance chart. The increase in SPY vs the increase in WALCL. Did you know the Fed reduced the balance sheet briefly at the start of 2009? That was yet another confirmation point of the QT thesis.

If I back up the chart a few months to October, you can see how tight the fit was until Trump was elected. That is my explanation for the 2016 to 2018 run. Trump's corporate tax cuts had a meaningfully positive impact on stocks. Additionally, before QE there was no correlation between stocks and the Fed's balance sheet because the Fed's balance sheet was rising so slowly it might as well have been a flat line. We should see stocks and the Fed's balance sheet uncorrelated in a normalization scenario.

Here is WALCL with VIX. It isn't a 100-percent correlation, but anyone in the markets since 2009 will remember the 2010 flash crash, 2011 correction, and 2015-2016 correction that really got underway with the yuan depreciation in August 2015. All of which came when there was no QE. And the QT period we covered above. The repo crisis of September 2019 that was swept under the rug by stealth QE4. Here we are again with QE5 ended and QT2 about to begin next month.

QT2

Back in 2018, the Fed's QT program peaked at $50 billion per month ($30 billion treasuries and $20 billion in MBS) in October. Two months later, the Fed panicked and ended balance sheet reduction.

This time, they want to phase in over about three months to a peak of $95 billion per month, composed of $60 billion in treasuries and $35 billion in MBS.

What do you propose will happen? 

On top of all this evidence, former Fed bank president Dudley called for the Fed to knock stock prices lower as part of a tightening effort. He all but confirmed what many have speculated, that rising stock prices is the real goal of QE. By extension, if the Fed wants to reverse QE via QT, should it not want to see equities decline at least at the start? Rising stocks signal the market "doesn't get it" or that the market thinks the tightening isn't enough. Bulls cannot win because if stocks go higher, the Fed will come back with a tighter policy until the equity market finally cracks under the pressure.

Trading QT2

The Fed started QT1 in October 2017 and it wasn't until it accelerated in January 2018 that the market finally cracked. It would take until October 2018 for the broader market to finally enter a sustained sell mode. There were many trading opportunities before then. Emerging markets fell steadily throughout the year as one example. I've been posting charts of stocks and sectors I see as weak now. 

As for when the major indexes start tumbling, I posit that it could start very soon. Earnings season is coming up and I already expect there will be more warnings and negative guidance in the mode of the Restoration Hardware call. QT2 will hit in May as well and will quickly hit the maximum of $95 billion per month. Phasing in by thirds, month two (June) of balance sheet reduction will exceed the peak of QT1. If the Fed starts big and phases in two smaller bumps, May's asset sales could be on par with the peak of QT1.

In conclusion, a significant decline in equities could begin immediately if the market front runs QT. By June or July at the latest, stocks may have hit a tradable low substantially below current prices and also well below the February lows. Complicating factors include inflation, interest rates and geopolitical risk. Stocks could relentlessly fall if rates and inflation stay high, or they could experience a compressed panic drop followed by a big recovery if crude oil and the 10-year Treasury yield plummet with equities.