The Federal Reserve, during the recent financial crisis and later amid the COVID-19 pandemic, bought Treasury bonds and other debt. This was part of the effort to lower interest rates and increase the money supply at a time when financial conditions were contracting and potentially squeezing the economy. Thankfully, they were successful and probably staved off a severe economic contraction. However, the Fed’s balance sheet expanded from around $4 to about $9 trillion.
The Fed officials became uncomfortable holding such a large amount of public as well as private debt. The private debt was mostly mortgages which they had purchased from Fannie Mae and Freddie Mac. Yes, this supported the housing market during these times of crisis but was not really the Federal Reserve’s ongoing responsibility. So, for more than a year the Fed has been shrinking these holdings. This is called Quantitative Tightening (QT). They do this by not replacing maturing instruments and selling back into the market others. This has the effect of taking money back out of the financial system.
The effects of a tightening financial system are seen in higher interest rates, reduced availability of credit, and potentially a contraction in the general ability to conduct business. We are seeing this in the stock market. There simply is not as much liquidity available as there has been. Stock trading is thin, resulting in far bigger moves on less and less volume. There is more of a tendency for stocks to retreat than advance. Fewer companies lead the market as there simply is not as much money to fund higher prices.
At some point, hopefully soon, the effects of QT will diminish and the economy and everything with it will decelerate to a more sustainable rate of activity. Then, our stock market can get back to analyzing company prospects without the overwhelming effects of draining liquidity. That may be close at hand; stay steady my friends.
The Lonely Bull