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Quantitative Tightening – Generating profits during the impending volatility epidemic

The Global Financial Crisis of 2007-2009 is considered by many to be one of, if not the most, extreme periods of financial and economic instability in modern history – rivalling the great depression of the 1930s. Liquidity evaporated, asset prices plummeted and individual and institutions alike defaulted under mounting debt pressures. Policy makers needed to act quickly and aggressively to prevent complete chaos.

The Federal Reserve in the US initiated the Zero Interest Rate Policy (ZIRP) in mid-2007, slashing the Fed Funds Rate from 5.25% in August 2007 to 0% by the end of 2008. This was unfamiliar and uncomfortable territory for US policy makers, forcing them to conduct monetary policy with their policy rate at the effective lower bound.

Due to the persistence and severity of the recession, it quickly became clear that traditional monetary policy alone was not enough to stabilise the global economy, another policy tool was needed.

Enter Quantitative Easing (QE).

QE, also known as ‘large-scale asset purchases’, is an expansionary monetary policy that involves a central bank purchasing large amounts of government bonds or other financial assets, increasing liquidity and stimulating economic growth.

In March of 2009, the Federal Open Market Committee announced that they would purchase 750b USD of Mortgage Backed Securities (on top of the 600b USD of MBS’s purchased over the prior 3 months), and 300b USD of Treasury Securities. This policy has come to be known as QE1, and marked the official beginning of the Feds Quantitative Easing program.

In November of 2010 the Fed announced that it would purchase a further 600b USD of treasury bills at a rate of 75b per month, QE2 concluded in June 2011.

In December of 2012, the Fed announced a third round of quantitative easing, allowing for the purchase of up to 40b USD of Mortgage Backed Securities and 45b USD of Treasury bills per month until the labour market improved ‘substantially’. Due to the open-ended nature of the policy QE3 came to be known as QE-Infinity. The Fed began tapering QE3 in December 2013 and officially ended its monthly purchase program in October of 2014.

Over the 5-year QE program, the Fed’s balance sheet increased from ~900b USD to ~4.5t USD, meaning that over 3.5t USD of liquidity has been injected into financial markets around the world. This has necessarily resulted in the inflation of asset prices – one of the main goals of QE. The below chart shows equities (particularly US equities) have enjoyed fantastic gains as the Fed’s balance sheet expanded.

 

S&P500

 

So, this means that the QE experiment was a success, right?

In a way, yes. Asset prices have risen, inflation is no longer missing in action and unemployment has fallen, allowing the Fed to start moving interest rates back towards the target range of 3% – 4%.

But, as any physicist or six-year-old will tell you – ‘what goes up must come down’.

From the end of QE3 until the end of 2017 the Fed has been running quantitative accommodation – maintaining its current balance sheet by holding existing assets and rolling treasuries at expiry.
However, in November 2017 the Fed announced that it was going to start gradually unwinding its massive balance sheet. Instead of rolling its existing treasury bill portfolio the Fed will now let these assets expire upon maturity, effectively withdrawing liquidity from financial markets.

It was going to start quantitative tightening.

As shown, the liquidity provided by quantitative easing has been incredibly supportive of US equities over the past decade. This ‘free money’ has allowed businesses to expand, acquire new assets, pay off debts, compensate for slowing earnings growth, and has allowed financial market participants to purchase large amounts of stock – all of which has inflated stock prices.

The question has become – are the valuations we saw throughout the highs of 2018 reflective of fair value, or simply a result of a decade of excess liquidity?

Well, to answer that question all we need to do is observe how markets reacted to the news that this ‘free money’ is going to be taken away.

 

S&P500

 

Where does this leave investors?

2018 was not an easy year for investors and its unlikely 2019 will be much better. The ‘buy and hold’ strategy that has worked so well for the past decade has not worked so well as of late. However, this doesn’t mean there isn’t money to be made during market volatility, in fact just the opposite. Volatility is an active traders’ friend, allowing directional trades to move into profit heavily and quickly. Volatility is also favourable for option traders, allowing option buyers to capitalise on large swings in underlying prices and option writers to charge higher premiums and more scope to adjust risk exposure.

Whether you want to hedge an existing portfolio or pursue alpha generating opportunities during the upcoming volatility Capital 19 can help. Get in touch with our team on 02 9002 0370 to see how we can help you reach your investing goals.

 

Join us for a free webinar next Thursday, Feb 28 at 7 pm.

“How you can Profit in a Volatile Market”

Presented by Matthew Jones

Click to register.