Risk: Hikes May Be Over, But QT Goes On

Before breathing a sigh of relief that rate hikes may have ended, investors may want to pause. Further tightening by major central banks still goes on in the form of quantitative tightening, posing an increasing risk to stock markets around the world.

Central banks appear to be ending their interest rate hiking cycles with the Bank of England (BOE) and Swiss National Bank surprising last week with pauses instead of hikes, joining a growing list of central banks that have put further increases on hold. Yet, monetary policy tightening continues with quantitative tightening (QT) underway at most major central banks. QT is the unwinding of quantitative easing (QE), when central banks reverse their former QE program asset purchases by not reinvesting maturing bonds and/or by selling bonds, to reduce the overall size of their balance sheets. During last week's meeting, the BOE Monetary Policy Committee voted 5-4 to leave rates unchanged at 5.25%, but all nine members voted in favor of increasing the pace of quantitative tightening from £80B this year to £100B over the next 12 months.

QE and QT policies impact the stock markets primarily through the phenomenon referred to as the "portfolio rebalancing effect," where investors take more risk in search of return in the markets in response to QE pushing yields lower, or reduce holdings in risky assets when QT drives yields higher and making bonds more attractive. This effect manifested in a sharp rise in the S&P 500 price-to-earnings (PE) ratio during the pandemic-related QE program and its subsequent decline in 2021-22 as the Federal Reserve tapered that QE program, as illustrated in the chart below.

Historically, there have been only two main international experiences of QT to draw lessons from. The U.S. 2017-19 episode, during which the U.S. Federal Reserve reduced its asset holdings by around $750 billion (after a total increase of $3.7 trillion in the previous eight years) at the same time as the European Central Bank and Bank of England ended their QE asset purchase programs. The 2006-07 Japanese experience, during which the Bank of Japan (BOJ) reduced its balance sheet from 155 trillion yen to 100 trillion yen, reversing nearly all the increase over the previous five years.

Limited experience with QT prevents us from being overconfident in using history as a guide to stock market performance during the current QT period. Yet, the previous two periods had similar effects on the stock markets.

• Prior to the Global Financial Crisis of 2008-09, only the BOJ had engaged in QE and so it was alone in unwinding it in 2006-07. In March 2006, the BOJ began a one-year reversal of the entire rise in its balance sheet since QE began in 2001. Over the year that followed March 2006, Japan's Nikkei 225 Index exhibited higher volatility, saw a peak-to-trough decline of 19% and was relatively unchanged for the full 12 months with a rise of just 1.3%.
• The QT by the U.S. Fed took place from October 2017 to September 2019. During that period, stock market volatility increased with a peak-to-trough decline of 19% and the S&P 500^® price-to-earnings ratio contraction of 25% peak-to-trough. In fact, 2018 was the worst year for the S&P 500 in a decade, and the worst year that did not include a recession since 1994. From when the Fed's balance sheet began to shrink noticeably in late January 2018 to when it began to rebound in late August 2019, the S&P 500 index was relatively unchanged for the full period, losing -0.2%.

This year, the QT-driven shrinking of central bank balance sheets may be increasingly acting as a drag on the overall stock market, although a handful of artificial intelligence-related stocks have been able to pull the stock market higher. If central banks continue QT, it may be increasingly harder for stocks to post gains on such narrow leadership.

This can be illustrated in the U.S. where the seven megacap tech stocks (Nvidia, Meta, Alphabet, Amazon, Microsoft, Apple, and Tesla) are headquartered. If we exclude these seven megacap tech stocks, the S&P 500 index is flat year-to-date for 2023.

With the potential to weigh on valuations, increase market volatility, and limit stock market performance, QT may become a bigger focus for investors now that rate hikes may have ended. The CBOE Volatility Index, or VIX, is a real-time market index representing the market's expectations for volatility over the coming 30 days. In mid-September, the VIX index fell to the lowest level since before the pandemic. Additionally, both the MSCI World Index and S&P 500 have not seen a move of more than 2% in either direction for many months. The exceptionally calm stock markets around the world may be ripe for a rise in volatility in the fourth quarter.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.