Many investors and Wall Street strategists have cited Quantitative Tightening (“QT”) as a risk for the stock market which has resulted in investors missing the 2023 rally and being too conservative about 2024. Most Wall Street strategists have targets in the 5,000 range for the S&P, indicating less than 3% upside for the year. What most market participants do not appreciate is that the Fed’s balance sheet and the Fed Funds target rate are nearly 100% linked. In other words, to achieve a given level of the Federal Funds Rate, the Fed must expand or contract its net balance sheet to increase or decrease bank reserves to keep the rate within the target band.
The Fed conducts what is known as open market operations almost every day to increase or shrink bank reserves to maintain the Fed funds rate. Open market operations are conducted by lending funds to money center banks through repo that injects reserves or borrowing money from the Street through reverse repo to shrink reserves. Paying interest on reserves makes it somewhat easier to maintain the target rate but, nevertheless, does require the Fed to maintain its net balance sheet at a level consistent with the then-current target rate.
Almost no one is aware that the Fed was forced to offset most of the QE that was occurring during 2021 to ensure that the Fed Funds Rate did not go negative. In fact, the Fed was required to build up over $2.0 trillion of reverse repo (borrowings from money center banks) to offset the excessive QE that was being executed. To implement the rapid increase in the Fed Funds rate during 2022, the Fed shrank the monetary base and bank reserves by over $1 Trillion or 20%, which precipitated a sharp decline in both stock and bond prices. To effectuate the increase in rates, the Fed was forced to supplement QT with another $600 billion of reverse repo to accelerate the shrinkage of bank reserves and the monetary base.
During 2023, the Fed was forced to more than offset its balance sheet run-off by reducing reverse repo by over $1.6 trillion, which resulted in a dramatic expansion of bank reserves and the monetary base of $400 billion or 8%. Consequently, the critical driver of the Fed’s net balance sheet is not the stated QT run-off rate, but rather the Fed Funds target rate, and investors should not consider QT or QE as a separate dynamic affecting the economy or capital markets, but rather a natural consequence of changes in the target rate.
Interest rate cuts are a powerful driver of stock and bond prices, not just because of the impact of lower rates, but also the powerful impact of the increase in liquidity required to be injected by central banks to effectuate those rates. We saw this impact during 2021, as the excess liquidity injected by the Fed caused a bubble in bitcoin, meme stocks, SPACs, and the housing market. Consequently, we are very bullish about the global stock and bond markets during 2024 as it is extremely likely that the year will be characterized by a wave of global central bank rate cuts, which will require a dramatic expansion of the Global Monetary Base (see www.infracapfunds.com). This liquidity injection is likely to drive both stock and bond prices significantly higher.
We forecast that inflation will roll off very rapidly during the first quarter of 2024 in both the US and Europe due to base effects. This dramatic decline in inflation will set the stage for a wave of global rate cuts and liquidity injections starting in the summer, which should cause the S&P to reach our target of 5,500 by the end of 2024.