The Fed's Quantitative Tightening: Run(off) for the Hills?

The following is an excerpt from our May 17, 2022 Morning Briefing.

Monetary Policy I: The Big Runoff. In recent conversations with our accounts, we have been hearing more concern about the second round of quantitative tightening (QT2), which starts next month. The first round of quantitative tightening (QT1) lasted from October 1, 2017 to July 31, 2019 (Fig. 1).

The fear is that QT2 will push interest rates even higher than would be the case if the Fed focused only on raising the federal funds rate while replacing maturing securities on its balance sheet. By letting maturing securities run off, there could be more upward pressure on interest rates as the fixed-income markets are forced to finance more Treasury and agency debt as well as mortgage-backed securities. In previous tightening cycles, with the exception of QT1, the Fed raised the federal funds rate without running off its balance sheet. This time, such rate hikes could be amplified by QT2.

Indeed, the rapid rise in interest rates so far this year may very well have been exacerbated by the Fed’s stated intention to start QT2 during the second half of this year. On January 5, the Fed released the minutes of the December 14-15, 2021 FOMC meeting revealing that the committee’s members were turning much more hawkish and were seriously discussing quantitative tightening. Indeed, there was a section in the minutes focusing just on “Principles for Reducing the Size of the Balance Sheet.”

The consequences of the Fed’s pivot from its ultra-easy monetary policy since 2008 to a tightening monetary stance are still ongoing and not in a good way for stocks and bonds. The 2-year US Treasury yield has soared from 0.73% at the start of this year to 2.61% at the end of last week (Fig. 2). The 10-year US Treasury yield has jumped from 1.52% to 2.93% over this same period. The S&P 500 dropped 16.1% from its record high on January 3 (just before the minutes were released on January 5) through Friday’s close, led by a 21% plunge in its forward P/E from 21.5 to 17.0 over this period (Fig. 3 and Fig. 4).

The concern is that because the Fed has fallen well behind the inflation curve, Fed officials now are about to err on the side of haste—tightening too much too fast with a monetary cocktail of rising rates and a declining balance sheet. That may very well bring inflation down, but with a hard landing for the economy too. That’s not our expectation, but it is a widespread fear. We continue to put the odds of a hard landing/recession at 30%.

Monetary Policy II: The Runoff Plan. Following the May 3-4 meeting of the FOMC, the Fed issued a press release titled “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet.” It noted that “all Committee participants agreed to the following plans for significantly reducing the Federal Reserve’s securities holdings.” Here are the details:

(1) First three months of QT. During June through August, the Fed will reduce its balance sheet by running off maturing securities, dropping its holdings of Treasury securities by $30.0 billion per month and its holdings of agency debt and mortgage-backed securities by $17.5 billion per month. So that’s a decline of $142.5 billion over the next three months.

(2) QT after August. Starting in September, the runoff will be set at $60 billion for Treasury holdings and $35 billion for agency debt and mortgage-backed securities. That’s $95 billion per month and $1.14 trillion over a 12-month period (Fig. 5).

(3) No terminal amount or date. There’s no amount set or termination date specified for the QT2. The press release simply states that “the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.” Assuming that QT2 is terminated at the end of 2024, the Fed’s holdings of securities would decline by $2.8 trillion, to $5.7 trillion from $8.5 trillion, in May.

Monetary Policy III: How Big Is the Runoff Shock? Now let’s discuss the impact of the Fed’s runoff plan on the fixed-income markets from a flow-of-funds perspective. In particular, what flows might either exacerbate or offset the bearish impact of the Fed’s plan? Consider the following:

(1) Federal deficit. In effect, running off the Fed’s balance sheet by $95 billion per month amounts to adding $1.14 trillion to the US federal budget deficit on a 12-month-moving-average basis. This deficit was $1.2 trillion through April, the narrowest it has been since March 2020 (Fig. 6).

Over the 12 months through April, the Fed’s holdings of US Treasuries rose $0.8 trillion. Consolidating the income statements of the US Treasury and the Fed into one shows that their combined deficit was $0.5 trillion through April (Fig. 7). However, starting next month, the Fed in effect will be a seller rather than a buyer of US Treasuries.

The good news is that the federal budget deficit has declined significantly since it reached a record high of $4.1 trillion through March 2021, narrowing to $1.2 trillion through April of this year. Outlays, also on a 12-month basis, have dropped 20% since they peaked at a record $7.6 trillion during March (Fig. 8). Federal government receipts have been soaring to record highs since April 2021, led by an almost vertical ascent in individual income-tax receipts (Fig. 9). Total federal tax receipts are up 31.5% y/y through April, led by a 53.8% jump in individual income-tax receipts. Yes, Virginia, inflation is a tax, and it is showing up in federal tax receipts.

Since tax receipts are up much more than inflation, is the economy much further from the edge of recession than widely feared? Actually, some of the past 12 months’ tax receipts were boosted when the IRS pushed back the 2021 filing deadline for a second year in a row, both to ease pandemic-related complications for taxpayers and to give them extra time to take advantage of the numerous tax provisions created by the American Rescue Plan.

The bad news is that the federal government’s outlay on net interest paid rose to a record high of $404.2 billion over the 12 months through April (Fig. 10). This item will be heading higher in coming months, reflecting the rise in interest rates.

(2) Foreign capital inflows. In addition to inflation boosting federal tax revenues, another offset to the Fed’s runoff is massive net capital inflows, which have been boosting the dollar in the face of record current-account deficits. Monthly data compiled by the US Treasury show that total net capital inflows added up to $1.34 trillion during the 12 months through March, matching the previous month’s record high (Fig. 11). Over this same period, the total private net capital inflow rose to $1.58 trillion, while the total official net capital inflow was -$238.3 billion (Fig. 12).

Here are the major components of the 12-month private net capital inflows through March: total ($1.6 trillion), bonds ($634 billion), Treasury bonds ($405 billion), government agency bonds ($115 billion), corporate bonds ($115 billion), equities (-159 billion), Treasury bills ($143 billion), and other negotiable instruments ($318 billion). (See Treasury International Capital Data for March.)

(3) Bank purchases. Commercial banks have been major purchasers of US Treasury and agency securities. Over the past two years through the week of May 4, their holdings rose $1.5 trillion (Fig. 13). However, they may be starting to reduce their holdings now that their loan demand seems to be improving.

(4) Bond funds. Last year saw record inflows into bond mutual funds and ETFs (Fig. 14). The 12-month sum of these inflows peaked at a record $1.0 trillion during April 2020. However, these funds saw net outflows totaling $45.1 billion during the three months through March of this year, when bond yields soared (Fig. 15). Weekly data estimated by the Investment Company Institute show that new outflows continued through the May 4 week (Fig. 16). The question is whether interest rates have risen high enough to attract retail and institutional bond buyers. The recent stability in bond yields suggests that some nibbling has started.

Monetary Policy IV: The Previous Runoff. During QT1, the Fed’s holdings of securities was pared by $675 billion from $4.2 trillion to $3.6 trillion. QT2 would reduce the Fed’s balance sheet at a much faster pace, by more than $1.0 trillion over the next 12 months for starters. The Fed terminated QT1 earlier than expected because economic growth slowed. Let’s look at the impacts that the Fed’s past tapering episode had on various key financial variables for some guidance on what might be in store for us as the Fed starts QT2:

(1) Monetary aggregates. During QT1, M2 continued to expand at about the same pace as in the years prior to the program (Fig. 17). On the other hand, demand deposits were noticeably flat compared to the years prior to the program (Fig. 18).

(2) Bond yield. The 10-year US Treasury bond yield rose from 2.33% at the start of the QT1 period to peak at 3.24% on November 8, 2018. It then fell sharply to end the period at 2.02% (Fig. 19).

(3) Stock market. The S&P 500 was quite volatile during QT1, which included a taper tantrum during the last three months of 2018 (Fig. 20). But it managed to rise 18.3% nonetheless over the QT1 period.

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