The Unknown Risks of Quantitative Tightening (QT)

Financial markets have been fueled by uncertainty in 2022.

Will the?bear market continue? Or was?June the market bottom?

There is also debate about whether the economy is in a?recession. See this WSJ article:?A Different Take on the U.S. Economy: Maybe It Isn’t Really Shrinking.

I say po-TAY-to (contracting). You say po-TAH-to (stagnating).

Meanwhile, Fed Chairman Jerome Powell said not to focus on the spuds! ??

?? "While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses."

?? "Reducing inflation is likely to require a sustained period of below-trend growth."

?? "We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done."

The Fed is laser-focused on taming inflation, and it's still elevated well above the 2% target.

When the Fed keeps hiking rates into decelerating growth, the risk in the stock market is rising.

Perhaps the biggest unknown is the mystery of how Quantitative Tightening (QT) will affect markets. The?Federal Reserve is set to reverse its previous policy of Quantitative Easing (QE),?a form of monetary policy used by central banks to increase the domestic money supply and spur economic activity.

QE in 2020, a response to the global pandemic, was massive in scale when the Fed rapidly purchased $3.3 trillion in US government bonds and $1.3?trillion?in agency mortgage-backed securities (MBS.) As of March, that left the US central bank owning a quarter of all outstanding Treasury debt and a third of agency MBS. The Fed is now reducing its bond holdings.?Fed Chairman Jerome Powell has suggested that QT could go on for two and a half years, implying that the Fed’s $9 trillion balance sheet would shrink by roughly $2.5 trillion.

The Fed has only once tried gradually shrinking its balance sheet back?in 2017?under then Fed chair Janet Yellen who said QT would be so predictable it would be like “watching paint dry.” It ended up being abandoned after September 2019 when overnight repurchase agreements (or "repos",) which are short-term loans between financial institutions, experienced a sudden and unexpected spike and required emergency intervention.

This time around, the Fed plans to shrink its balance sheet more aggressively than in 2017. By next month, the Fed aims to ramp up the pace at which it is scaling back its portfolio to a maximum speed of $95 billion per month, split between $60 billion of Treasuries and $35 billion of agency MBS.

Some think the current path for QT does not pose a risk to markets because it has been well-communicated and is likely reflected in current market prices. Nevertheless, QT is a form of the Fed taking away the punch bowl so we view it as another potential negative for the financial markets.

In this financial hurricane, I'm keeping my head down and eyes open. Shelter from the storm and make hay when the sun shines.

Andrew Wang, Managing Partner

Will the Fed successfully tame inflation and markets resume an upward bias? Is QT priced into the market currently or is it a blind spot?