Will Quantitative Tightening Overwhelm The Markets?Advisor Perspectives
Inflation is running hot, and the market is projecting seven rate increases this year alone. As if that is not concerning enough for bond investors, the Fed is hinting at draining liquidity via balance sheet reduction, i.e., quantitative tightening (QT).
At Jerome Powell's post-March 16, 2022, FOMC press conference, he stated: “It's clearly time to raise interest rates and begin the balance sheet shrinkage.” Based on further comments, Powell wants to start normalizing the Fed's balance sheet and drain liquidity as early as May.
Since March of 2020, the Fed has bought about $3.5 trillion in U.S Treasury securities and $1.5 trillion in mortgage debt. The gush of liquidity from the Fed's quantitative easing (QE) program caused the U.S. Treasury to run massive pandemic-related deficits. Buying over half of the Treasury's debt issuance in 2020 and 2021 limited the supply of bonds on the market and put upward pressure on interest rates.
Equally important to the Fed, QE comforted investors in March of 2020 and further boosted many asset prices throughout its existence.
With QE finished and QT on the horizon, I answer a few questions to help you better appreciate what QT is, how it will operate, and discuss how draining liquidity will affect markets.
What are QE and QT?
QE is the process in which the Fed purchases Treasury and mortgage bonds from banks. In exchange, the banks receive reserves from the Fed. These reserves are not cash, but are the basis by which banks can lend money. As such, there is an indirect connection between QE and money printing.
Via QE operations, the Fed removes assets from the markets. The supply reduction creates a supply-demand imbalance for the assets it buys and the entire pool of financial assets. As a result, QE tends to help most asset prices. For this reason, QE has become the Fed's most important tool for fighting market instability and thereby boosting investor confidence.
For more on how QE supports asset prices, I suggest reading my article- The Fed is Juicing Stocks.
QT is the opposite of QE. During QT, the Fed shrinks its balance sheet. QT has only been attempted once. In 2018, the Fed embarked on QT, as circled in the graph below. At the time, it reduced the balance sheet by $675 billion. Ironically, the liquidity drain forced the Fed to return to QE in 2019 as hedge funds ran into liquidity problems. QT exposed the fragility of our overleveraged financial system and its reliance upon easy money.
Perspective on QE 4
How did the massive pandemic round of QE (QE4) compare to prior rounds of QE? Eric Parnell summed it up nicely:
- For example, it took the Fed more than a year to deploy $300 billion in Treasury purchases as part of QE1. In response to COVID, the Fed purchased $300 billion in Treasuries in just three days.
- It took the Fed nearly eight months to carry out $600 billion in Treasury purchases as part of QE2. During the COVID outbreak, the Fed made $600 billion in Treasury purchases in six days.
- And it took the Fed 22 months to carry out $1.5 trillion in Treasury purchases as part of QE3, which until COVID was considered the epic QE program. But during COVID, they matched this $1.5 trillion in Treasury purchases in just over a month.
- And then they continued gobbling up Treasuries at a rate of $80 billion per month, or nearly $1 trillion a year, for the next year and a half through late 2021 before FINALLY starting to wind the program down.
How much QT might the Fed do?
The rectangle in the graph above highlights the massive $5 trillion increase in the Fed's balance sheet over the last two years. With the Fed funds rate on the rise and inflation the number one enemy of the Fed, numerous Fed members have made it clear they want to normalize the Fed's balance sheet.
Does “normalizing” mean the Fed will reduce the $5 trillion it recently increased it by?
To help us guesstimate what normalization entails, we lean on Joseph Wang and his blog Fed Guy. Joseph was a senior trader on the Fed's open market desk responsible for executing QE and QT. As such, he understands the mechanics of QE and QT better than just about anyone else.
In his more recent article The Great Steepening he stated:
Chair Powell has sketched out the contours of the upcoming QT program through a series of appearances. He noted at a recent Congressional hearing that it may take around 3 years to normalize the Fed's $9t balance sheet. The Fed estimates its “normalized” balance sheet based on its perception of the banking system's demand for reserves. A conservative estimate based on the pre-pandemic Fed balance sheet size and taking into account growth in nominal GDP and currency, arrives at a normalized balance sheet of around $6t. This would imply QT at rate of ~$1t a year, roughly twice the annual pace of the prior QT.