There is a fair amount of confusion around quantitative tightening, or QT, the Federal Reserve’s effort to shrink its balance sheet after buying trillions in bonds over the past two years. That makes sense, given that QT gets far less airtime than interest-rate hikes, and the technical details of QT operations are somewhat complicated and opaque.
But it is increasingly important to have a handle on what is happening on the quieter side of this tightening cycle because QT is about to ramp up. Investors need to know how balance-sheet tightening is working now to appreciate what is to come.
When the central bank began QT in June, it set out to partially unwind roughly $4.5 trillion in quantitative easing, or QE, that was conducted in response to the pandemic. The Fed started by letting up to $30 billion in Treasuries and $17.5 billion in mortgage-backed securities, or MBS, roll off its balance sheet, as opposed to reinvesting the proceeds. Starting next month, those caps will rise to $60 billion and $35 billion, respectively, meaning the pace of balance-sheet runoff is about to double. Fed Chairman Jerome Powell has suggested that QT would go on for two to 2½ years, implying that the Fed’s $9 trillion balance sheet would shrink by roughly $2.5 trillion.
That sounds easy enough. But there is a two-part problem around investors’ perception of QT. First, Wall Street seems to have a blind spot when it comes to tightening via the Fed’s balance sheet. Such tightening has been attempted only once before, and economists say rate increases are much easier to model than quantitative tightening. In that way, many participants assume QT won’t have much impact. Second, the lack of discussion around QT is leading to public misunderstanding. Some investors doubt that the Fed is following through so far on its balance-sheet tightening plan, particularly on the MBS side. That sentiment makes sense when one looks at a chart of the Fed’s MBS portfolio, but it means that investors may get caught off-guard in the coming months.
To understand what is actually happening and yet to come, Barron’s spoke with Joseph Wang, former senior trader on the Fed’s open markets desk. The Fed is conducting QT as it has said it would, Wang says, and he dispels growing skepticism that the Fed hasn’t been willing or able to shrink its balance sheet, at least for now. But people are confused, Wang adds, in particular because it looks like the Fed’s MBS holdings aren’t decreasing, and as if they even may be increasing.
Wang says the saw-toothed pattern in the Fed’s MBS holdings is the result of accounting issues. First, there is a gap between when MBS purchases settle and when holders of MBS receive payments. Second, the Fed has a three-month window for settling MBS purchases. The Fed is the largest single investor in the MBS market, and Wang says the central bank can try to minimize potential disruptions by postponing settlements if it thinks doing so will improve market functioning.
That means mortgage-backed securities purchased by the Fed three months ago could just be showing up. QE ended in March, but it isn’t that simple. Strategists at BofA Securities note that since March, the Fed hasn’t been adding securities, but it has been reinvesting paydowns. Starting in August, the MBS portfolio will begin to decline, but they say the decline won’t become more apparent until November. That is because August is the last month when paydowns should exceed the redemption caps, as the cap for MBS runoff rises to $35 billion. Wang notes that the Fed estimates it receives about $25 billion a month in principal payments, meaning it should no longer have reinvestments to deal with, and that factor offsetting QT will cease.
September and beyond is when Wang warns something is apt to break, not unlike what happened the last time the Fed embarked on QT, and chaos in the repo market prompted an early end to the program. It is also the time when Fed officials may decide whether to outright sell MBS. But he notes that a recent hint by the Treasury that it may buy back older, less liquid Treasuries could help QT go a bit more smoothly.
Some strategists are more worried. Solomon Tadesse, head of quantitative equities strategies North America at
says markets still aren’t fully factoring in QT. While some economists say balance-sheet tightening will more or less run on autopilot, in the way that now–Treasury Secretary Janet Yellen in 2017 as Fed chairwoman said QT would be akin to watching paint dry, Tadesse says that expectation is silly.
That is in part because in order to bring inflation back to 2%, the Fed needs to shrink its balance sheet by about $3.9 billion—significantly more than what investors expect, Tadesse says. By his calculations, QT alone would amount to about 4.5 percentage points in additional rate hikes.
“I don’t think there is appreciation for QT, by markets or the Fed,” Tadesse says. “In the end, if QE mattered, so will QT,” he says, referring to the big lift quantitative easing gave to risk assets. “It might not be totally symmetrical, but there will be a meaningful impact.”
The spirit of Tadesse’s view is one way to square investors’ growing expectations for rate cuts to begin next year with the fact that consumer price inflation is over 9%. It is possible markets are accounting for additional tightening via QT, even if it isn’t as much as Tadesse says is necessary.
Consider what Ed Yardeni, president of Yardeni Research, estimates. He says QT will represent the equivalent of at least a half-point rate hike, and probably closer to a full-point increase. That’s not to mention the impact of a 10% run in the U.S. dollar this year, which Yardeni says is equal to another hike of at least 0.5%.
But even if the relatively aggressive QT that starts next month means fewer rate increases are ultimately needed, investors should brace for added volatility. The Fed is entering the unknown, and so are markets.
Write to Lisa Beilfuss at [email protected]