During the pandemic, the Federal Reserve took various measures to stimulate the economy and encourage the smooth functioning of markets. One action the Fed took during the pandemic was quantitative easing (QE), where it buys bonds to boost money supply and asset prices.
However, the reversal of this policy, called quantitative tightening (QT), is what has JPMorgan Chase (JPM -0.02%) CEO Jamie Dimon concerned. During QT, the Fed reduces the balance sheet holdings accumulated during the pandemic. According to Dimon, QT is "in no way traditional Fed tightening" and could pose a significant challenge to markets and the broader economy. Here's what investors should know, how it could impact the stock market, and what you should do about it.
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This Federal Reserve turned to this stimulus measure during severe economic contractions
The past decade and a half has seen significant fiscal spending in the economy and Federal Reserve interventions. The pandemic-era stimulus was likely appropriate; after all, it kept the economy out of a tailspin.
The Fed implemented QE during the pandemic, a stimulative policy that injected money into the financial system. QE is where the government purchases financial assets from banks and other institutions, such as Treasury bonds and mortgage-backed securities. The goal of QE is to reduce volatility in markets and try to promote economic growth. It also increases the price of those assets they buy and is another way the Fed can influence interest rates.
Through QE, the Fed purchases those bonds from banks, which increases the amount of banking reserves in the economy. Increasing the supply of reserves helps lower interest rates and provide liquidity to the banking system, allowing banks to increase the amount of credit available to borrowers, creating a stimulative effect.
The Fed first ramped up QE during the Great Recession, increasing its total assets held from around $900 billion to $4.5 trillion from 2008 to 2014. During the pandemic, the Fed's assets held due to QE more than doubled, from about $4 trillion to nearly $9 trillion by 2022.
US Total Assets Held by All Federal Reserve Banks data by YCharts
Quantitative tightening could result in "a massive change in the flow of funds"
Inflation began to rear its ugly head early in 2021. Later that year, the Federal Reserve announced it would reverse its stimulative policies, raise interest rates, and begin reducing its balance sheet holding through quantitative tightening (QT).
QT is the process of shrinking the Fed's balance sheet and reducing those holdings it built up during the pandemic and Great Recession. This process can be done in different ways, but the Fed primarily does it by allowing maturing Treasuries to "roll off" the balance sheet, allowing these bonds to mature without reinvesting the proceeds. The only other time the Fed attempted QT was from 2017 to 2019, leaving little evidence to understand how this process impacts the economy.
Dimon raised his concerns in JPMorgan Chase's 2021 letter to shareholders. The CEO said that the shift from QE to QT would cause a "massive change in the flow of funds in and out of Treasury bonds," impacting other asset values along the way. He went on to say that today's situation in the economy is unlike 2008 to 2014 when central banks bought bonds so that banks and other institutions globally could deleverage as the economy emerged from that financial crisis.
With QT, central banks are reducing their holdings at the same time governments across the globe have more significant debts they need to finance by selling bonds. As a result, Dimon says the impact of QT could push longer-term rates higher than most market participants expect.
What does QT mean for the stock market?
We're already seeing some of the effects of QT. For example, since the start of 2022, after the Federal Reserve announced it would restart QT, the U.S. 10-year Treasury bond yield has gone from around 1.5% to 4.2%, while the U.S. 30-year Treasury bond yield went from around 1.9% to 4.3%.
10 Year Treasury Rate data by YCharts
This tightening of monetary policy has resulted in volatility in the stock market for most of last year and in bond markets over the last two years. Banks have also seen the impact of tighter policy, with deposits falling by over $1 trillion.
If QT continues pushing interest rates higher, its effects could "expose additional weaknesses in the economy," according to Dimon, leading to further volatility in the bond and stock markets as the new year approaches.
Here's what investors should do
QT's effect on the stock market and the economy remains a big question, and Dimon admitted as much. However, as CEO of the largest bank in the U.S., Dimon's job is to assess the risks in the economy and prepare the bank for those potential risks (even low-probability tail risks) to navigate challenging times.
Your job as an investor is to have a plan and stick to it for the long haul. The best thing you can do is consistently invest in the stock market. Since 1929, the S&P 500 index (made up of about 90 stocks at the time) has returned an average annualized return of 9.8% through the end of last year. That period includes depressions, multiple recessions, wars, inflation, and asset bubbles.
Long-term investors, not those trying to time the market, ultimately come out on top. According to a study by JPMorgan Asset Management, if you invested in the S&P 500 index from 2002 through 2021, you would have earned an annualized total return of 9.5%. However, if you attempted to time the market and missed out on the 10 best days, your annual return would've been cut in half at 5.3%.
As long-term investors, it's important to stay disciplined, think in terms of years, not days or months, and view dips as opportunities to add to your investments on the cheap. With a long-term mindset, you can better weather short-term volatility, keeping you on track to achieving your financial goals.
