It has been a brutal month for the market, with the Dow Jones Industrial Average down about 7.4%, or more than 2,370 points, in September.
The main culprit has been the hawkish Federal Reserve, which not only continued to aggressively raise interest rates but also continues to forecast more big rate hikes ahead this year. The market now firmly believes a more severe recession is inevitable in 2023 once these rate hikes fully work their way through the economy.
But on Wednesday, after days of selling, the Dow suddenly ripped roughly 549 points higher. The surprising move had nothing to do with any change in policy by the Fed, but can be attributed to a big decision made by the Bank of England, which inadvertently saved the stock market.
Pivoting across the pond
Like pretty much everywhere else in the world, the U.K. has been dealing with extremely high inflation. This has forced the Bank of England to become more restrictive with its policy -- including raising its key benchmark rate, which has been at low levels for many years now.
The Bank of England has also been planning to reduce the size of its balance sheet in a process known as quantitative tightening (QT), in which the bank runs off bonds on its balance sheet, which effectively removes liquidity from the economy.
Image source: International Monetary Fund Flickr.
These moves are seen as restrictive because higher rates reduce the future cash flows of companies, hurting their earnings power, and leading to lower earnings estimates and therefore lower valuations. They also make riskier assets less appealing because safer government bonds yield more.
While the effect of QT is more of an unknown, one general thought is that it soaks up liquidity that might have been inflating assets like stocks or real estate. Lots of central banks all over the world are being restrictive right now to deal with high levels of inflation.
To make matters worse for some economies, if you've been watching the foreign exchange markets, the U.S. dollar has been surging this year and recently hit a 20-year high. The British Pound Sterling, which a year ago traded at about $1.37, recently hit an all-time low, falling below $1.03. The situation intensified this week when British Prime Minister Liz Truss recently proposed a slate of tax cuts that investors feared would exacerbate inflation, leading to the abandonment of the pound and government debt.
On Wednesday, the Bank of England stepped in to try to stabilize the market by saying it would purchase long-term government bonds, which is the opposite of QT. The pound did respond positively and had risen close to $1.09, as of this writing.
Between now and Oct. 14, the Bank of England plans to buy around 65 billion pounds worth of long-term British bonds (equivalent to roughly $70 billion), and also said it would delay its plan to start reducing its balance sheet, which was supposed to begin next week. The central bank plans to buy as much 5 billion pounds of bonds per day that mature in no less than 20 years.
Why did this move lift the stock market Wednesday?
If QT is viewed negatively for stocks, then a sudden reverse in which the Bank of England begins purchasing bonds (quantitative easing) and effectively pumping liquidity back into the economy is a positive event for stocks.
It could also support the idea that the Fed could suddenly pivot and return to the easy-money policies it has employed for the last decade, which could explain why U.S. markets rode the wave Wednesday. There has been a camp of U.S. investors who believe the Fed would not stay hawkish for much longer.
Still, the Bank of England is only trying to do this to stabilize the pound and still wants to reduce its balance sheet, so this sudden pivot could be temporary, especially if the pound is able to stabilize.
