Fed Chair Jerome Powell, shown at a post-meeting press conference late last month, has suggested the balance sheet contraction could last up to 2½ years.
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There has been quite a bit of confusion about quantitative tightening, or QT, the Federal Reserve’s attempt to shrink its balance sheet after buying trillions of bonds over the past two years. That makes sense, given that QT gets much less airtime than rate hikes, and the technicalities of QT operations are somewhat complicated and opaque.
But it’s increasingly important to get a handle on what’s happening on the quieter side of this tightening cycle, as QT is about to rise. Investors need to know how balance sheet tightening works now to appreciate what’s to come.
When the central bank started QT in June, it planned to partially unwind about $4.5 trillion in quantitative easing, or QE, which was conducted in response to the pandemic. The Fed started by rolling up to $30 billion in government bonds and $17.5 billion in mortgage-backed securities, or MBS, off its balance sheet, rather than reinvesting the proceeds. Starting next month, those limits will rise to $60 billion and $35 billion, respectively, meaning the rate of balance sheet drain is about to double. Fed Chair Jerome Powell has suggested that QT would take two to 2½ years, implying that the Fed’s $9 trillion balance sheet would shrink by about $2.5 trillion.
That sounds easy enough. But there is a two-part problem surrounding investor perception of QT. First, Wall Street appears to have a blind spot when it comes to tightening through the Fed’s balance sheet. Such tightening has only been attempted once before, and economists say rate hikes are much easier to model than quantitative tightening. That way, many participants assume that QT won’t have much of an impact. Second, the lack of discussion about QT leads to public misunderstanding. Some investors are questioning whether the Fed is following through on its balance sheet tightening plan so far, especially on the MBS side. That sentiment makes sense when you look at a chart of the Fed’s MBS portfolio, but it means investors could be caught off guard in the coming months.
To understand what is really happening and what is yet to come, Barron’s spoke to Joseph Wang, a former senior trader at the Fed’s open markets desk. The Fed is conducting QT as it has said, Wang says, dispelling growing skepticism that the Fed has not been willing or able to shrink its balance sheet, at least for now. But people are confused, Wang adds, especially since it appears that the Fed’s MBS holdings are not decreasing and even increasing.
Wang says the sawtooth pattern in the Fed’s MBS stock is the result of accounting problems. First, there is a gap between when MBS purchases settle and when MBS holders receive payments. Second, the Fed has three months to settle MBS purchases. The Fed is the largest individual investor in the MBS market, and Wang says the central bank may try to minimize potential disruptions by delaying settlements if it believes it will improve market functioning.
That means mortgage-backed securities bought by the Fed three months ago may just show up. QE ended in March, but it’s not that simple. Strategists at BofA Securities note that the Fed has stopped adding securities since March, but has reinvested the payouts. From August, the MBS portfolio will begin to decline, but they say the decline will not become apparent until November. That’s because August is the last month in which payouts should exceed redemption limits as the MBS runoff limit rises to $35 billion. Wang notes that the Fed estimates that it receives about $25 billion a month in principal payments, meaning they should no longer have to make reinvestments, and the factor that offsets QT will disappear.
In September and beyond, Wang warns that something is about to break, similar to what happened the last time the Fed entered QT, and chaos in the repo market led to an early end to the program. It is also the time when Fed officials can decide whether to sell MBS entirely. But he notes that a recent hint from the Treasury that it could buy back older, less liquid government bonds could help QT run a little smoother.
Some strategists are more concerned. Solomon Tadesse, Head of Quantitative Equity Strategies North America at
Société Générale
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says markets still don’t fully factor in QT. While some economists say balance sheet tightening will be more or less on autopilot, as it is now — Treasury Secretary Janet Yellen in 2017, as Fed Chair said QT would be akin to paint drying, Tadesse says that that expectation is foolish.
That’s partly because to bring inflation down to 2%, the Fed will need to shrink its balance sheet by about $3.9 trillion — 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’s any appreciation for QT, by markets or the Fed,” Tadesse said. “Ultimately, if QE mattered, so will QT,” he says, referring to the big improvement that quantitative easing gave risky assets. “It may not be completely symmetrical, but there will be a meaningful impact.”
The spirit of Tadesse’s vision is a way of reconciling investors’ growing expectations for the rate cuts starting next year with consumer price inflation above 9%. It is possible that markets will account for additional tightening via QT, even if not as much as Tadesse says is needed.
Consider what Ed Yardeni, president of Yardeni Research, estimates. He says QT will be the equivalent of a rate hike of at least half a point, and probably closer to a full point hike. Not to mention the impact of a 10% rise in the US dollar this year, which Yardeni says equates to another rise of at least 0.5%.
But even if the relatively aggressive QT that kicks off next month means fewer rate hikes are ultimately needed, investors should brace for additional volatility. The Fed is entering the unknown, and so are the markets.
Write to Lisa Beilfuss at [email protected]
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