The US Federal Reserve (Fed) officially launched quantitative tightening (QT) on Wednesday (1st), shrinking its balance sheet that has reached 8.9 trillion US dollars, and raising interest rates to fight inflation, which means that financial conditions will be further tightened , financial markets will face headwinds.
1. What is QT and how does it work?
Quantitative tightening (QT) is the opposite of quantitative easing (QE) and basically aims to reduce the money supply in the real economy.
Starting June 1, the Fed will reduce its balance sheet holdings of U.S. Treasuries, agency debt and mortgage-backed securities (MBS) to absorb excess liquidity by allowing securities in its hands to mature without further investment of proceeds. Although the scheduled time is June 1st, the first batch will not expire until June 15th.
According to the QT plan announced by the Fed’s May decision-making meeting, starting in June, the monthly scale of the balance sheet was reduced to $47.5 billion ($30 billion in government bonds and $17.5 billion in MBS), and by September, the scale expanded to $95 billion per month . The last time the shrinking started in 2017 had a maximum size of $50 billion per month, indicating that this shrinking is faster and more aggressive.
2. Impact assessment is difficult
The main impact of QT is in financial markets, pushing up real yields on government bonds (that is, inflation-adjusted yields) and thus making stocks less attractive.
It is unclear how much impact the reduction will have. Fed Chairman Powell said in a May press conference that there is an estimate that the Fed’s QT plan is equivalent to an additional rate hike (25 basis points), but the range of predictions is very wide, “There is no certainty that QT will be bring those effects.”
Wells Fargo Investment Institute estimates that the Fed’s balance sheet will shrink by nearly $1.5 trillion by the end of 2023 (to $7.5 trillion), equivalent to a rate hike of 3 to 4 yards (75 to 100 basis points) The target range rose to 3.25-3.5%.
The Fed will next meet on June 14-15. Minutes from the May meeting showed the Fed was watching the risks of the follow-up to the balance sheet reduction, with several officials concerned that there might be “unanticipated potential consequences” for financial conditions.
3. Market turmoil
Wells Fargo Investment Institute said the potential for QT to push up real yields, coupled with other forms of tightening financial conditions, means risk assets will face further headwinds.
The last time the Fed ended its rate hike cycle was said to be partly related to financial market turmoil caused by the shrinking of its balance sheet. This time, in order to suppress inflation and tighten financial conditions, the Fed chose to implement QT while accelerating interest rate hikes, which may make the already volatile bond market more volatile and trigger a decline in technology stocks once more.
On the other hand, the additional interest rate hike effect brought regarding by the shrinking balance sheet will help to reduce inflation more significantly, which is good news for the Fed and Powell, who are actively suppressing inflation in the case of high energy prices.
Analysts at TD Securities have warned that QT will send financial markets down an unpredictable path. They predict that the reduction of the balance sheet will be implemented until the end of 2024 or early 2025. The market can usually absorb the impact of the tightening in the early QT, but the impact of this layer will not develop linearly, and may even become stronger over time.