Ok, Ok. “Doomsday scenario” is a bit hyperbolic. But I didn’t say it – it’s a quote from this WSJ article.
METARs have been discussing the impact of the Federal Reserve’s increase of the fed funds rate. But the fed funds rate is just an overnight rate. The longer-term interest rates are much more important to the economy since they determine mortgage, corporate bond yields, etc.
Quantitative Easing (QE) by the Fed has bought $8.8 Trillion of Treasuries and mortgage-backed securities (MBS) using fiat money created out of thin air. That was monetary stimulus which suppressed long-term interest rates. (For comparison, U.S. GDP is $25 Trillion.) QE pumped up all asset values, including bonds, stocks, real estate, etc. with ultra-cheap lending.
Starting in June 2022, the Fed began to very gradually reduce their massive, bloated book of bonds by letting them roll off – not buying new bonds as their existing bonds mature. This is called Quantitative Tightening (QT). The minuscule pace is scheduled to double in September.
**The Other Doomsday Scenario Looming Over Markets**
**A U.K. fund manager says the big worry isn’t inflation, it’s the Fed reversing quantitative easing**
**By James Mackintosh, The Wall Street Journal, Sept. 3, 2022**
**London-based Ruffer LLP is concerned that the accelerating runoff of the Fed’s Treasury holdings will suck liquidity out of the markets — just as rising rates and falling stock and bond prices increase the need for cash to smooth the drop....**
**The Fed doubles the pace of its bond runoff this month, aiming to reduce its Treasury holdings by $60 billion and its mortgage-backed securities by $35 billion monthly. Those concerned about the impact include hedge fund giant Bridgewater, which thinks markets will fall into a “liquidity hole” as a result. ...**
**Ruffer expects widespread withdrawals from fund managers after the terrible year they’ve had, forcing sales of stocks and bonds. If banks are constrained and unwilling to deploy money, they won’t cushion price declines and markets could drop suddenly....**
**There are enough other issues — especially the market’s failure to prepare for weaker earnings next year — to keep me bearish on stocks, but inflation makes cash an expensive place to hide. Still, QT is a risk to watch closely, because it’s only boring until it suddenly isn’t.** [end quote]
Inflation does make cash an expensive place to hide. The place to hide cash, for the moment, is in short-term Treasuries, TIPS and GSE bonds (short-terms available on the secondary market). Since QT involves the Fed rolling off MBSs, I expect the yields on GSE bonds to rise in September and beyond.