It’s goodbye QE, hello QT, as central banks end easy money ride for stock markets amid runaway inflation

Markets, used to thinking that the worst case is an increase in the cost of money, are unprepared for the money being taken off the table. The risk of a stock market collapse is real and the next crisis could be in shadow banking

Anthony Rowley

Published: 9:30pm, 17 Apr 2022

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Through it all, stock markets have stood tall – or so it would appear. Trade wars, bond market “taper tantrums”, the Covid-19 pandemic, return of inflation, rising interest rates, war in Ukraine and now economic sanctions – stock markets have survived the lot. Can nothing shake them?

Well, yes, it can, and soon will, judging from what should be (but apparently isn’t) the obvious fact that markets are about to transition from QE to QT – from quantitative monetary easing to quantitative tightening. This will be a whole new ball game, one that most countries haven’t played.

It is the potentially shrinking “quantity” of money rather than its rising cost that will knock stocks off their pedestal. Stock investment is no longer connected to corporate earnings or economic fundamentals; it is about the capacity of financial institutions to bankroll investors.

These institutions have long been able to finance a bull market in stocks because central banks, led by the US Federal Reserve, were willing to backstop commercial bank lending by acting as lenders of last resort. Now, the central bank attitude is changing, along with the nature of credit creation.

We’ve all become familiar with QE as central banks increased the quantum of money in the system by buying financial securities from the market. But QT is less familiar except for a brief episode in 2019 when the Fed tried it, before backing off in alarm at the effect on market sentiment. Why should they follow through with tightening this time when they backed off before?

US Federal Reserve Chairman Jerome Powell speaks during a virtual press conference on March 16, raising interest rates for the first time since 2018. Photo: Xinhua

The answer is that toppling the towering stock market is now seen as the lesser of two evils compared to the wealth-destroying potential of the runaway inflation taking hold in the United States, Europe and beyond.

Is the coming sell-off of financial assets held by the Fed and other central banks big enough to sink global stock markets which, according to Statista, were capitalised at more than US$116 trillion at the end of last year, with the New York Stock Exchange and Nasdaq accounting for nearly half of that?

The Fed holds some US$9 trillion of assets (more than double the amount in early 2020), taking the total assets of the world’s major central banks to more than US$30 trillion – more than a quarter of the value of global stocks. Even if central banks were to run off most of these assets, that might not appear big enough to sink stock markets.

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But the psychological impact on the market, of central bank decisions to cut the absolute size of their asset holdings (not just cut the size of new purchases) is what matters. It would signal the end of an era of seemingly limitless credit expansion, and that would have a big impact on investors.

In addition, the cost of money appears certain to go on rising relentlessly this year and maybe well into the next as central banks continue to raise lending rates by increments that can only increase in size as the tornado of fuel, food and other commodity prices roars onwards.

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Could all this presage not only a stock market collapse but also a financial system crisis similar to what occurred during the 2008-09 global financial crisis? This is held to be unlikely as commercial banks are now better capitalised and better regulated.

But this is too blithe an assumption. So-called shadow banks (hedge funds, mortgage lenders, money market funds, insurance companies and so on) play a much bigger role in lending now, and unlike commercial banks, many are not subject to official regulation. So the next crisis could be in shadow banking.

As International Monetary Fund economists Antonio Garcia Pascual and Fabio Natalucci observed in a recent blog: “Emerging firms are quickly making inroads into critical financial services, and often taking on more risk than traditional banks [ …] Digital banks are growing in systemic importance in their local markets.”

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Known as “neobanks”, these digital banks are more exposed than their traditional counterparts to risks from consumer lending, and their exposure extends to higher risk-taking in their securities portfolios. They thrived under QE but they are unlikely to prosper or even survive under QT.

The QT exercise, as Credit Suisse Japan’s chief economist Hiromichi Shirakawa noted during a webinar that I moderated in Tokyo recently, could be the trigger for a long-delayed correction in stock markets, especially as other central banks are joining the Fed in balance sheet unwinding.

This simple but important point is often overlooked because markets have become accustomed to thinking that the worst that can happen is an increase in the cost of money rather than money being taken off the table. Markets may have “priced in” the tightening of QE but not yet the impact of QT.

Investors, except for those who have been around long enough to know better, do not realise that the danger is of the “punch bowl” being snatched from their hands, rather than simply having to pay more for each heady draft they consume.

Inflation has been fed by the sacrifice of monetary caution to avert economic recession and financial collapse following the global financial crisis and the pandemic. Ironically, it is inflation that threatens now to precipitate those very things as financial excess takes its toll.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs

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