Quantitative tightening is about to intensify. What does that mean for the markets?

The Federal Reserve now owns about a third of the Treasury and mortgage-backed securities markets as a result of its emergency asset purchase to support the US economy during the Covid-19 pandemic. Two years of so-called quantitative easing doubled the central bank’s balance sheet to $9 trillion, equivalent to 40% of the country’s GDP. By adding a lot of liquidity to the financial system, the Federal Reserve helped support big gains in the stock, bond, housing and other investment asset markets.

Now, with inflation rampant, the Fed is unlocking this liquidity via a process known as Quantitative tightening, or qt. In June, the central bank began shrinking its portfolio by allowing up to $30 billion in Treasuries and $17.5 billion in mortgage-backed securities, or MBS, to settle its balance sheet, or mature without reinvesting the proceeds. Quantity It will double this month It actually begins on September 15th, with Treasury bonds redeeming in the middle of the month and at the end of the month.

QT is as ambitious as its impact is uncertain. At full speed, the pace of balance sheet tightening will be more aggressive than in the past, and come at a time when interest rates are rising rapidly. What can go wrong? Probably, a lot, suggests Joseph Wang, a former trader at the Federal Reserve’s Office of Open Market and author of the Fed Guy blog and Central Banking 101. Wang explains what is at stake in the following modified conversation.

BaronHow will quantitative tightening unfold, and how will accelerated recoveries affect the market?

Joseph Wang: When the economy was not doing well, quantitative easing pressured interest rates and increased liquidity in the financial system. Now he wants the Fed Tightening financial conditions. QT increases the amount of Treasuries available to investors while reducing their cash holdings. Mechanically, the US Treasury issues new debt to the investor and uses the proceeds of the issuance to pay off Treasuries held by the Federal Reserve. The Fed receives that money and then simply cancels it — unlike during quantitative easing, when the Fed produced cash out of thin air.

When you increase the supply of bonds in a market that is not very liquid, and when the marginal buyer changes as the Fed goes down, you will get volatility. The markets just haven’t figured out what that means. We are likely to see higher returns for fixed income. Higher returns affect stocks in a number of ways. There is a portfolio rebalancing effect, whereby losses on the bond side of the portfolio cause the investor to sell some shares to rebalance. QT also reflects the impact of risk on quantitative easing, which occurred when many yield-seeking investors moved to riskier assets or long-term Treasuries.

This happens at a time when Treasury releases are on the rise. Why is this important?

Market prices are determined by supply and demand, and in the coming years, there will be a massive supply of Treasuries coming from two sources. First, there is the budget deficit that the US government is experiencing. While the deficit will shrink slightly this year compared to last year, the Congressional Budget Office says the path is essentially $1 trillion annually for Treasury issuances for the foreseeable future. The second source of additional supply is Qt. Together, this will increase the supply of Treasuries to historically high levels of about $1.5 trillion this year and next. Before Covid, the net supply was about $500 billion.

On the demand side, the marginal buyer is changing as the Fed exits itself from the Treasury and mortgage markets. Hedge funds are not there. The Federal Reserve does not exist. And the banks are not there. We will not have to go through the price discovery phase. Consider the context: Treasury market liquidity is weak at the moment. There is some fragility, and it is likely to be emphasized with increased QT.

Speaking of a marginal buyer, who is going to fill the void while the Fed pulls back? Can these markets function without the Federal Reserve?

I’m not sure who the new buyer is, which is why I think there could be a lot of fluctuation in interest rates. But new buyers can be manufactured through the policy. One way is through a treasury buyback program, where the treasury becomes a large buyer of treasury bonds. The Treasury Department recently introduced this idea. Another way in which banks can be encouraged to buy new is through regulatory changes, whereby regulators reduce the capital requirements of banks, thus encouraging them to buy more government debt.

But the point is, if the issuance is growing by a trillion dollars a year, it’s hard to say that there will be enough marginal buyers. We are trapped in a world where There will always be quantitative easing, because the Fed will eventually have to become the buyer again. The growth in treasury issues is faster than the market can handle alone.

Keep in mind that over the past 20 years, the amount of Treasury securities outstanding has more than tripled, but the average daily volume in the money market has grown much more slowly. This is inherently unstable. It’s like a stadium that gets bigger while the number of exits remains the same. When a lot of people need to get out, as happened in March 2020, the market has problems.

Fed officials say they don’t know much about how Qt is doing. why is that?

QT’s gameplay will depend on moving parts, many of which are out of the Fed’s control. First, there is uncertainty about what the Treasury releases. It can issue a lot of long-term Treasuries, which the market will be more difficult to digest, or Treasuries with a shorter history, which the market can digest more easily. Depending on what the Treasury does, the market may have to digest more term, which it will be subversive treasury market Where liquidity is already weak.

Where liquidity exits is also outside the Fed’s control. When the Treasury issues new securities, they can be purchased either by cash investors, such as banks, or leveraged investors, such as hedge funds. When they are purchased by leveraged investors, the money that goes to fund them most likely comes from the Federal Reserve’s Reverse Repurchase Facility, or RRP, an overnight lending program that you can think of as excess liquidity in the financial system.

If newly issued Treasuries are bought by leveraged investors, it drains liquidity that the financial system doesn’t really need, so the effect is neutral. But if the newly issued securities are bought by cash investors, someone takes the money from the bank and uses it to buy Treasuries to pay off the Federal Reserve. In this case, the banking sector loses liquidity, which can lead to disruption, because it is possible that someone somewhere depends on that liquidity. This is what happened in September 2019 when the repo market stalled and the Fed was forced to add more reserves.

You seem worried that something will break again. why?

It is impossible for the Fed to know how liquidity will be drained from the financial system. But we can look at who’s buying today, and the buying comes almost entirely from the banking system, as opposed to parties like hedge funds. The RRP has held steady at around $2 trillion since the beginning of the year. So it looks like QT will drain liquidity from the banking sector rather than the resettlement scheme.

This is the opposite of what the Fed wants. Officials assumed they could aggressively increase the pace of QT, because they see a lot of liquidity parked in the RRP. What they may not understand is that how liquidity is drained is out of their control. And at the moment, as noted, it is getting out of the banking system.

Federal Reserve Chairman Jerome Powell said in July that the QT period will last between two and a half years. This suggests that the Federal Reserve’s balance sheet will shrink by about $2.5 trillion. Is this a realistic assumption?

The Fed believes that QT is constrained by the amount of liquidity that banks need to function well. They feel the balance sheet could drop by about $2.5 trillion, and it would be fine. But remember that the Fed does not have much control over how it drains liquidity. They seem to want the banking sector to have reserves in excess of $2 trillion. At the moment, the banking sector owns about $3 trillion. The only way QT can move forward as currently expected is to ensure that liquidity is drawn more evenly from the financial system – which means more cash out of the resettlement scheme versus the banking sector. If the Fed can’t find a way to strike that balance, it may have to stop early. But there are ways they can make this work.

what are they?

There are two basic solutions to the problem of draining excessive liquidity from the banking sector while much remains in the resettlement scheme. First, the Fed can do what it did in the fall of 2019 and start buying a lot of Treasury bills. From the Fed’s point of view, buying bills is different from quantitative easing. They are essentially exchanging short-term assets for reserves, which are also short-term assets, deliberately adding reserves to the system without affecting interest rates.

Second, and most likely, the Fed could work with the Treasury. If the treasury makes buybacks by issuing short-term bonds and uses the proceeds to purchase long-term coupons, it will transfer the liquidity from RRP to the banking system because the treasury bonds will be purchased by money market funds with funds held in RRP. Voucher-to-treasury sellers then deposit the money into a commercial bank. Moving funds from the RRP to the banking system will allow the Fed to move forward with QT without having to worry about liquidity in the banking system that is declining so much.

Will the Fed end up selling Mortgage-Backed Bonds?

Her plan is to put up a maximum of $35 billion a month in mortgages for the agency, but she estimates she will only be able to make $25 billion a month. Unlike Treasuries, whose principal is paid in full on the due date, mortgage loans can be paid off in advance. For example, if a person who owns a home is refinancing, they take out a new loan to pay off an old one. When selling a home, they may use the proceeds to pay off the mortgage. All of this is slowing down as mortgage rates rise.

Selling MBS is another tool the Fed has to tighten financial conditions, but it doesn’t look like they want to roll it out. In the past few months, the housing market has experienced a significant downturn. I imagine they want to see how this is done before financial conditions in housing further tighten.

Thanks Joseph.

write to Lisa Belfuss at lisa.beilfuss@barrons.com

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