Score Triple-Digit Gains While the Fed Tightens Its Belt

Shah Gilani|September 1, 2022

While Wall Street, investors, the media, and the public are hyper-focused on the Federal Reserve’s rate hiking policy path, the same trap door markets fell through in 2018 is about to open wide, and nobody’s talking about it.

The trap door is the Fed’s quantitative tightening (QT) plan, the opposite of its bull market friendly quantitative easing (QE) program. Starting this September, as in right now, the Fed’s accelerating their QT operations, meaning the unwinding of their $9 trillion balance sheet.

Raising rates while simultaneously amping up QT will be the straw that breaks the camels’ backs, meaning the stock market and the bond market.

Here’s what happened in 2018 when the Fed began quantitative tightening, what markets did, and what’s different (as in worse) this time.

But most importantly: here’s how to make a few hundred percent returns trading the selloff.

The Last Time This Happened, The Markets Tanked

Back in early 2018, on the heels of the U.S. economy seeing robust GDP growth of 5.2% in 2017, the Fed began raising the federal funds rate, which is the interest rate big banks charge each other for overnight loans.

At their meeting on March 3rd and 4th that year, the FOMC (Federal Open Market Committee) raised the fed funds rate by 25 basis points (25 bps), lifting it to a target range of 1.5% to 1.75%.

They raised the target rate 25 bps again three more times at their meetings in June, September, and December, ultimately taking fed funds to a target range of 2.25% to 2.50%.

Which is exactly where fed funds are today.

In conjunction with raising rates, the Fed announced at their May 2018 meeting that they’d be starting quantitative tightening, shrinking their then $4.441 trillion balance sheet by $95 billion a month.

The plan was to let $60 billion worth of Treasuries and $35 billion of MBS (agency mortgage-backed securities) a month “runoff” the balance sheet. Running off means not replacing maturing bonds. For years, the Fed had been buying an equivalent amount of treasury bills, notes, bonds, and MBS that were constantly maturing out of their balance sheet.

Not buying replacement bonds means the Fed isn’t in the market as a buyer every month. It means other investors have to step up their buying. If they don’t, bond issuers, meaning the U.S. Treasury and mortgage securitizing banks, would have to raise the interest they offer investors to attract buyers.

That’s how the Fed uses QT to push rates upwards along with their direct targeting of the fed funds rate.

From the beginning of the year to the end of 2018, the Fed shrank its balance sheet by $385 billion.

The rate hikes and QT didn’t bother markets, which saw the S&P 500 rise steadily from May to October, until the end of the year.

Higher rates and tighter economic conditions, including liquidity issues in the all-important repo-market, upset markets. Frighteningly, from October 1, 2018 to Christmas Eve., December 24, 2018, the S&P 500 fell over 20%.

That scared Fed chairman Jerome Powell and the FOMC into an almost instant “pivot” in early January.

The Fed stopped QT altogether and began easing (meaning lowering rates) again.

We’re seeing the same patterns taking place now. But conditions on the ground are different, and that’s going to have a big impact on how this shakes out.

Second Verse, Worse Than the First

Back then, the economy was coming off GDP growth of 5.2%. But today, GDP isn’t growing, it’s shrinking.

Back then, inflation was running at a 2.49% clip. But today, inflation’s running at an 8.5% clip.

Back then, the Fed’s balance sheet was just north of $4.45 trillion. Today, it’s just south of $9 trillion.

Back then, the federal funds target rate got up to 2.25% – 2.50%. Today, it’s starting there.

Back then, with fed funds at 2.5% the Fed stopped QT altogether. Now, with fed funds at 2.5%, the Fed’s ramping up QT.

At the end of May this year, the Fed announced it would let $30 billion a month in Treasuries and $17.5 billion a month in MBS runoff its balance sheet for the next three months. Then in September, as in today, they’re raising the monthly runoff to $60 billion a month for Treasuries and $35 billion a month for MBS.

At that pace, by the end of 2022 the Fed’s balance sheet will be $522 billion lower. The 20% drop the market saw in 2018 was the result of higher rates and the Fed letting a similar amount runoff its balance sheet.

The Fed’s hinted at reducing its balance sheet by $4 trillion, about what it added since the start of the pandemic.

Imagine what a $4 trillion reduction in the Fed’s balance sheet would do to markets if a $550 billion runoff caused a 20% drop in the S&P 500?

Imagine what fed funds going to 4.75% – 5.00% would do to markets if bumping them up to 2.5% in 2018 sent stock market benchmarks into correction and bear market mode?

Rates are going higher and the Fed’s balance sheet is going lower. That’s a lose-lose situation for the stock market and the bond market.

We’re positioning ourselves, in my subscription services, for a bear market and a bond rout.

To make a killing on the crashing bond market, we’re “waterfalling” a trade we made earlier this year betting on rising rates and falling bond prices.

We used TBT, the ProShares UltraShort 20+ Year Treasury ETF, to rake in a 280% gain, then a whopping 800%, when rates started to rise. Waterfalling that trade means we’re doing it again, only this time we’re doubling down.

Buying TBT – or better yet, the right calls or call spreads on TBT – is what you might want to do as well, in order to make some triple-digit gains out of the beleaguered bond market.