Markets have been affected by inflation all year, with the Fed hiking rates to rein in high prices.
It's likely that that tool will weigh on stock and bond markets more than the rate hikes. Fears that quantitative tightening could end in a market crash have arisen because of a massive change in liquidity.
The balancing act of fighting inflation and keeping markets afloat is explained by two experts.
The Fed reduces the size of its balance sheet when it tightens its reins. Long-term government bonds, which eventually mature and allow the Fed to get back the principal on those bonds, are some of the assets the central bank has. The Fed can either keep the money or let the bonds run off. The Fed doesn't want to invest during quantitative tightening.
The effect of pushing rates higher is the same as if the Fed sold bonds into the market.
The Fed is reducing its holdings of Treasury bonds and mortgage securities. Real long-term interest rates are going to increase because of that.
It is hoped that it can reduce inflation. Real-long term interest rates affect asset prices. The kind of investment that stimulates inflation is discouraged by higher rates.
Higher interest rates can eat into corporate profitability and cause stock prices to go down.
QT removes a guaranteed buyer of debt securities from the market. Bubbles like the meme-stock craze that took hold of markets during the pandemic will diminish if the market is removed from a lot of liquid assets.
When long-term interest rates rise, investors will want to shift from stocks to bonds.
Michael Contopoulos, an analyst with the Reserve Bank of Australia, told Insider that quantitative tightening and interest rate hikes will likely put a lid on meme stocks.
It's also about other things.
It wouldn't be easy to just boil it down to that. He pointed out that the interest in stocks was due to the fact that a lot of the pandemic-eraStimulus money has gone out of savings. The Fed's rate hikes have made people less interested in stocks this year.
The stock market is down 20% year-to-date and with three-month government-guaranteed Treasuries yielding 4%, why risk your money?
Kermani believes that the Fed will need to slow the pace of its balance sheet reduction in order to keep the quantitative tightening regime going. Money coming off the balance sheet has mostly been coming from the excess reserves, which are used by banks.
According to Kermani, the financial system may not be able to tolerate banks' excess reserves dipping below $2 trillion, which could lead to the Fed stopping QT late in the 20th century. He said that the Fed would likely hold off on slowing the pace of quantitative tightening until there was clearer evidence of inflation.
According to Bank of America, even a shift from quantitative tightening to "tinkering" would boost the stock market.
Some experts have doubts about the benefits of an end toQT.
Territorial tinkering will have a short-term effect. The profit recession is about to start and will pick up steam in the years to come.
In the first six to nine months of this year, stocks were largely influenced by the Fed's actions, but later on in the year, Fed policy will have a smaller impact on stocks.
"I think the next leg of the race lower in stock prices is going to be driven more by the lack of earnings growth than it is by the Fed's actions."
As long as the Fed reduces its portfolio gradually, Kermani doesn't think quantitative tightening will cause a crash in stock prices. He doesn't think it's a good idea to stop the quantitative tightening process completely at this point.
The Federal Reserve should not change their mind because they are afraid of what will happen to stock prices. In a world where the Fed is in charge of stock market insurance, we don't want to live there. He thinks gradual adjustment of market prices is not bad.