The beginning of June 2022 marks the planned start of the Federal Reserve’s Quantitative Tightening (QT) program, a contractionary monetary policy tool intended to help curb hyperinflation in the US by reducing the money supply. Implemented in conjunction with the Federal Reserve’s plan to continue raising the federal funds rate by 50 basis point increments, this is a decisively hawkish agenda that will likely have an acute impact on the financial markets. Let’s explore further as we issue a warning: QT starting now.
A Brief History of QE/QT
QT is the ‘sibling’ program of Quantitative Easing (QE), its expansionary counterpart. QE is essentially a large-scale financial asset purchasing program that central banks utilize when their economy needs to be stimulated due to lower consumer spending, i.e., a mode of ‘money printing’. QE entails a central bank purchasing government bonds, mortgage-backed securities, and other assets to increase the money supply, creating new liquidity to encourage more lending, investment, and spending. QT has been described as the opposite of QE in the sense that it entails a subsequent central bank balance sheet reduction, effectively reducing the money supply and removing excess cash reserves to cool an overheated economy.
While the Bank of Japan is widely credited with pioneering QE in the early 2000s, the expansionary strategy was popularized by central banks around the world during the 2008 financial crisis. It saw even wider use in early 2020 onward, in attempts to combat global COVID-era economic catastrophe. However, despite its worldwide popularity, both QE and QT remain in their infancy, and are thus regarded as somewhat experimental programs.
Differences from QT in 2017
The last time that the Federal Reserve implemented QT was to reduce the size of its balance sheet back in 2017, after it had built up a (then) unprecedented $4.5 trillion portfolio. They began letting their securities mature gradually, starting around $10 billion per month and eventually quintupling that pace over the next few years. These measures, in conjunction with periodic interest rate hikes, correlated with relatively stable growth in the US economy.
Several variables have changed this time around: first, the rate hike agenda is far more aggressive than it was five years ago: Chairman Powell has made it clear that 50 basis point hikes are on the menu for now, a departure from the more modest 25 bp hikes of the past. The timeline for hikes is more rushed than in 2017 as well. Second, this iteration of QT’s pace is quicker as well, with security maturation caps expected to near $100 billion per month by the end of this year. This seemingly corresponds with the Fed’s balance sheet being just under $9 trillion this time, near double that in 2017. Third, the US economy does not seem to be weathering this transition well, with a 1.5% contraction in Q1 GDP and a sharp drop in value for the US stock market (in part due to supply chain issues, ubiquitous hyperinflation, and volatile geopolitical tensions).
The truth is, we are effectively in uncharted waters, so it is virtually impossible to know what consequences QT (or QE, belatedly) will ultimately have. However, considering our limited experience with it, one of two outcomes seems most likely: 1) QT will have an apparently mild/neutral effect on the US economy, to the point that its shrinking of the money supply is nearly imperceptible for buyers and sellers. Considering its historical correlation with economic growth, there is even a chance it could be seen as a slight bullish fundamental catalyst for the US stock market, a harbinger of the end of hyperinflation risks and woes.
2) Aggressive QT, concomitantly with rapid consecutive 50 bp rate hikes, will contribute to a recipe for recession in the US, encouraging investors to shy away from riskier securities in favor of government bonds, USD, and other safe haven assets. While this scenario seems most likely to me, today’s higher-than-expected NFP numbers showcase a resilient US economy and may have given the Fed more breathing room to pursue this hawkish agenda without recession looming. We will have to patiently keep tabs on other indicators going forward to monitor this.
Today I'll share some economic analysis on the CPI report and what to look for in order to tell if inflation will get worse. Lastly, I'll cover some ways that you can make an investment play on inflation.
The Consumer Price Index report for September 2021 was published on October 12, 2021. Prices increased for urban consumers by 0.4 percent in September on a seasonally adjusted basis. This is slightly higher than August which came in at 0.3 percent. On a 12 month basis, the CPI is up 5.4% from September 2020.
You have likely seen your gas prices so I don't need to tell you that prices are up, but it's worth noting how much. All major energy indexes are up this month. The entire energy index increased by 24.8% on a12 month seasonally adjusted basis. Gasoline is up 42.1% and Natural Gas is up 20.6% over the same period. Electricity also increased by 5.2%.
The index for food was up 4.5% over the past 12 months. The largest movers in the food index were meat products. Meat, fish, poultry, and eggs increased 10.5% and the index for beef is up 12.6% in the last year.
We've all heard someone in the last few months say something to the effect of : "40% of all dollars were printed in the last year" with an ominous reference to potential inflation. This is more or less correct as the US government has printed a ton of new dollars, but printing more money doesn't directly lead to inflation. If we look at the velocity theory of money we can understand why. The velocity of money is essentially a way of measuring how fast money changes hands, given the price level, GDP and money supply.
Rearranging this, we can see that the speed at which money changes hands is a function of the price of goods, the GDP and the Money supply. Price levels and GDP haven't shifted much, but the M money supply increased a lot. This means that the Velocity of money should be low. And velocity is very low.
This means that inflation hasn't hit us hard yet.. If inflation really starts to pick up, the velocity of money should see a noticeable increase as more dollars start to change hands to pay for the increased price of goods. This is demand inflation. Prices have increased in specific areas, but we have yet to see large scale inflation.
The Federal reserve has shown that it is hesitant to drastically increase interest rates from their near 0 levels, and are more than willing to increase the amount of assets on it's books. As a result the the amount of dollars in the system increases. Under normal circumstances, low interest rates and an increase in the money supply increases the demand for goods and services. But we haven't seen this. Why?
Individuals and businesses have thus far used PPE loans and government stimulus to pay off debts and cover their bases during the pandemic. Since these individuals and businesses can pay for the goods and services that they need, they don't demand more. There is no pressure for a demand shock at this time. The money generated by Fed is sitting idle in bank accounts, investments and institutions.
We are currently in a supply shock in the U.S., increasing in the price of select goods, but we haven't seen a drastic increase in demand or a change in velocity of money. This doesn't eliminate the possibility of future inflation though. That money is still in the system, and we could still be sitting on a powder keg.
Currently, I am looking at stocks and asset classes that I think will rise in the event of inflation. Ill share my methodology for my search and give some stocks that I think fit into this criteria. Ill try and explain why I think some industries will do well and why others will not. This is not advice, I am only sharing my opinion and observations.
Oil and Natural Gas Producers: Natural gas is up in price by 20.6% and Fuel Oil is up 41.7% since last year. Winter is coming in the United States and Europe and the prices for these commodities are already increasing. Couple this with inflation and supply problems, producers will benefit immensely from this. These guys find the material, and sell it. they only get more money if the price of the commodity goes up and people still need to full up their gas tanks and heat. their homes. The risk is that shipping problems could cause issues.
Coffee Producers and Futures : America has an addiction to coffee, this is no secret. An article from yahoo finance, described how Caribou Coffee is buying tons of Coffee beans in anticipation of supply shortages. This commodity shows robust demand despite price increases. One difficulty I see with this is finding the right way to invest in this commodity. I'm trying to avoid companies like Starbucks, Nestle and Keurig that sell coffee directly to consumers as they may not be able to pass on as the price increase. It seems like that is the only option aside from directly purchasing futures. One possibility is $JO, which is an ETF that tracks monthly coffee futures contracts.
Refiners and Pipelines: Avoid these like the plague if oil and gas prices go up. These companies take a hit when prices increase because they cannot pass prices onto their consumers quickly, yet they still have to meet the demand of consumers to stay in business.
Beef and Pork: If inflation hits this sector Americans will substitute out the expensive red meats for cheaper alternatives like chicken. This is due to the fact that most Americans have a predetermined budget for grocery shopping and will maximize the amount of food they get.
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