Understandably, much of the investing world – much of the world straight-up – has been focused on the geopolitical and economic fallout of Russia’s invasion of Ukraine. That conflict has implications for Europe and for commodity prices that are more serious than any we have seen in a very long time. Yet without minimizing the gravity of the crisis or its grim human toll, the risk for investors is that the conflict distracts them from another, perhaps more impactful, long-term development: namely, the most significant shift in monetary policy since the Global Financial Crisis.
In its next policy announcement, on March 16, the U.S. Federal Reserve is widely expected to announce the first in an anticipated series of interest rate hikes this year – important not just because this will be its first rate increase since 2018, but also because it comes in response to persistently above-trend inflation. But rate increases are only part of the equation, and the “two” in the Fed’s one-two policy punch is something with which investors might be less familiar: quantitative tightening, or QT.
That phase of the new regimen has not begun yet. (In fact, the Fed was still actively buying bonds until just a few days ago.) However, the Fed has telegraphed its intentions thoroughly enough that we can reasonably start to sketch out some scenarios about QT, its rollout and the likely impact on capital markets and the economy. When we do, it becomes clear that the Fed, along with other central banks undertaking QT, will be entering largely uncharted territory – and taking investors with it.
What is QT and when will the Fed start?
When the pandemic hit the global economy, the Fed’s response borrowed from the same playbook it wrote during the Great Financial Crisis: after lowering interest rates to zero, it bought up bonds to inject liquidity into the economy and keep yields low. Over the past two years, the pandemic round of quantitative easing has inflated the Fed balance sheet by about US$5 trillion – it now sits just under US$9 trillion in total, according to the central bank’s (Fed) latest weekly statistical release.
Quantitative tightening is just the reverse: the Fed will shrink its balance sheet by paring down its bond holdings, effectively reducing money supply and attempting to put upward pressure on rates. As we noted above, the Fed hasn’t started that process yet. And officials have strongly signalled that they do not intend to do so until after they begin to hike interest rates. In short, they would prefer to keep the two levers separate. The consensus right now seems to be a round of rate hikes into the summer, at which point QT will begin.
After that, who knows what the circumstances underpinning tightening policy might be? The world today looks a lot different than it did six months ago. It will probably look a lot different six months from now.
How can the Fed do it?
There are two main methods by which a central bank can conduct QT. The first is passive: the bank simply lets bonds mature and does not reinvest the proceeds into buying more bonds, effectively shrinking its balance sheet. The second approach is active: the bank reduces its balance sheet by selling securities outright. The only other time the Fed undertook QT, in 2018-2019, it adopted a passive approach. This time around they have signalled that it will once again be primarily passive, but haven’t ruled out active QT.
How far could QT go?
At US$9 trillion, the Fed’s balance sheet is, to put it simply, really big, which means it has plenty of room to trim. Few observers expect it to shrink all the way down to pre-pandemic levels (roughly US$4 trillion), but halfway back (that is, to around US$6.5 trillion) seems plausible. If the Fed gradually ramps QT to the point that it reduces its holdings by US$100 billion a month, then it would reach that target in a little over two years. Indeed, the Fed holds close to US$400 billion of T-bills maturing in less than three months, and more than US$750 billion of additional short-term bonds maturing in less than a year, according to the Fed’s weekly release, so even just a passive QT operation should reduce the balance sheet by approximately $1 trillion over the next year assuming reinvestment of maturing bonds is gradually reduced to zero.
The fiscal environment in the U.S. might also give the Fed more room to trim than markets expect. President Joe Biden’s multitrillion-dollar Build Back Better spending bill has all but died in Congress, and any replacement bill is likely to be a pale shadow of the original. As a result, the fiscal deficit seems guaranteed to come in smaller than it looked just a year ago, which translates into a lower volume of government bond issuance than markets might have anticipated. That could create greater market capacity to absorb the impact of QT, and it may also dampen some of QT’s potential negative impact on the economy.
What part of the balance sheet will the Fed target?
Treasury bonds comprise the biggest portion of the Fed balance sheet – about two-thirds of it. The rest is made up primarily of mortgage-backed securities (MBS), according to the Fed’s weekly statistical release. The Fed has long made it clear that it does not believe the U.S. Federal Reserve should be in the mortgage-backed securities business over the long term. So, to the extent the Fed targets one portion of its holdings over the other, it would make sense to prioritize reducing MBS.
If that turns out to be the case, then it would almost force the Fed to undertake active QT. Mortgage-backed securities tend to have long durations, so passively reducing its MBS holdings could take the Fed many years. Active QT through selling the securities would help it achieve its targets more quickly. It might also have a dampening impact on the U.S. housing market – which might not be an altogether undesirable outcome from the Fed’s point of view, given the red-hot state of housing recently.
How about other balance sheet effects?
So far, our discussion of QT has focused on the Fed’s assets. However, the liability side of the balance sheet also matters. While beyond the scope of this report, the source(s) of the reduction in Fed liabilities (which include the US Treasury’s General Account, bank reserves and overnight reverse repurchase agreements, among other items, and which must match Fed assets), could affect market liquidity and capital market prices.
What happens to the yield curve?
The answer hinges on whether the Fed takes a passive or an active approach. If it goes active, it could decide to sell short-duration bonds over long-duration bonds, or vice versa. The impact would be very different.
Selling short-duration bonds would put even more pressure on the yield curve to flatten – and the yield curve has already significantly flattened by about 1% to roughly 30bps (basis points) over the past six months, thanks to a big selloff in short-term bonds as the market has priced in rate increases. Fed officials might want to avoid exacerbating that scenario, given that a flattening curve may be a signal of over-tightening since it is a fairly reliable harbinger of recession.
On the other hand, actively selling long-duration bonds could put upward pressure on the long end of the curve – effectively steepening rather than flattening it. Of course, that would be bad news for long bond prices, but for the Fed a steeper curve could be very desirable. It might even mean it would need to make fewer interest rate hikes than the market is currently projecting. Indeed, some estimates suggest that a US$2 trillion-plus reduction in the balance sheet would be equivalent to three or four 25bp rate hikes.
Will other central banks follow suit?
The short answer is yes. In fact, the Fed is not the first out of the gate with QT, and other central banks’ QT programs will add to the global impact. The Bank of Canada, for one, has already outlined its approach. Over the next two years, it plans to undertake a fully passive QT program that will shrink its balance sheet by about 40%.
What’s the likely impact on capital markets?
It might not be as dire as some are expecting, at least in fixed income markets. True, yields might rise a bit, yet QT may not result in the huge bond selloff many might be anticipating. In part, that is because QT withdraws liquidity, acting as a brake on the economy. During the most recent round of QT, in 2018-2019, yields rose during the early phase but then fell as investors priced in slowing economic growth. That round of QT is not a perfect historical precedent, but something similar could happen this time around.
In equity markets, QT could present a significant headwind, as less liquidity and slower economic growth could translate into less support for the capital markets and slower earnings growth. Any deceleration in economic activity resulting from monetary tightening could prompt investors to move into more high-quality defensive sectors and away from (lower-quality) cyclical sectors. And somewhat ironically, a pronounced economic slowdown may lead to a return to growth equities, as opposed to the value stocks investors have favoured over much of the past year, since investors have historically favoured companies with proven abilities to grow in a slow growth environment. It is important to note, however, that equities have already declined in anticipation of tighter monetary policy. Once the slowdown has been sufficiently reflected in stock prices, a buying opportunity for equities should present itself as tightening begins to abate.
Of course, the adverse impacts on markets might be offset by any success the Fed has in threading the needle between tightening too much and not tightening enough. If it can engineer a soft landing for the economy, perhaps by steepening the curve through active QT without having to hike rates quite as much or as often, then maybe that is achievable. However, the odds are long, as the large majority of tightening cycles have eventually resulted in hard rather than soft landings.
Obviously, unknowns abound, although more details should be forthcoming starting as soon as the next Fed meeting later this week. In the meantime, it makes sense to start thinking about QT in terms of whether the Fed will sell securities (that is, conduct active QT) and, if so, what it will sell (MBS? Short bonds? Long bonds?). The answers to those questions could make all the difference for investors preparing to navigate a new era of monetary policy.
Related: War and the Fear of Recession
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