As the calendar flips to September, the Federal Reserve is about to go full QT. That’s as in “quantitative tightening,” a reversal of the central bank’s efforts to keep money flowing through the U.S. economy, most recently during the Covid pandemic. The program expanded the Fed’s balance sheet to about $9 trillion, easily the highest ever as it scooped up Treasurys and securities comprised of mortgage-backed bonds. This month marks the culmination of a summertime expansion of QT that now will see up to $95 billion a month in proceeds from maturing bonds roll off the Fed’s holdings, leaving market participants to pick up the slack. The run-off of the balance sheet began in June. Thus far, it has coincided with a time in which government bond yields actually have declined on net. But with Fed liquidity efforts serving as a major market backstop since quantitative easing — the market-friendlier side of QT — began in 2008, there are bound to be worries about unintended consequences. The targeted pace of reduction is “the fastest that the Fed’s balance sheet will have ever declined in its history, implying an uncertain market impact,” Citigroup economist Isfar Munir said in a recent client note. Supply and demand issues One of the biggest questions will be whether markets can absorb the excess supply that the Fed’s actions will generate. The Fed already ceased buying Treasurys and mortgage-backed securities earlier this year, then started allowing their holdings to reduce outright this summer. That has come at the same time that the central bank has been raising interest rates aggressively and Treasury issuance of notes and bonds has decelerated amid falling government budget deficits. “There are no visible stress points over the remainder of this calendar year,” said Lou Crandall, chief economist Wrightson ICAP. “We’ve got so much surplus liquidity that it’s going to be a while before there’s an immediate actual consideration for the market, as opposed to what’s on the horizon.” Indeed, one mitigating factor for QT is the sheer size of the Fed’s balance sheet . Even with three months of reduction under its belt, the Fed still has an asset portfolio of just over $8.9 trillion. That’s a reduction of just $63 billion since early June. As a size of the total balance sheet, this round of tightening is actually less than what the Fed did from 2017 to 2019. “The increased pace of balance sheet [reduction] will be matched by a similar paced decline in reserves,” Munir wrote. “Such an aggressive reduction in liquidity suggests monitoring market functioning, but our base case is that the ample level of reserves is more important than the rapid decline. Munir added that the actual total run-off could be closer to $85 billion, depending on how fast mortgage-backed securities paydowns run. The big question Crandall has, though, is how far the Fed can push QT before it actually does start to affect market functioning. After all, during the previous round, the Fed had to halt after running off just $800 billion or so amid signs of economic weakness and market tumult. The housing market is in tumult as demand has weakened dramatically and mortgage rates have soared. These are all factors the Fed will have to weigh as it continues its efforts to slow an economy that is generating inflation close to the fastest level in more than 40 years. “This has all been baked in the cake for months now,” Crandall said, referring to market expectations for Fed tightening. But he adds a pressing issue next year will be, “How much can the Fed shrink its balance sheet given the demand for liquidity out there?” Factors in the Fed’s favor One factor the Fed has working in its favor is a high investor level of demand for safe-haven government securities given the generally volatile market conditions these days. Treasury auctions, particularly for longer-dated debt, have been well subscribed mostly, despite the rising rate and the vanishing Fed backstop. “Investors are still going to be looking for paper in a way that we’re not used to,” said veteran investment banker Christopher Whalen, head of Whalen Global Advisors. “We’re used to worrying about people issuing paper and whether there would be enough demand. But you still have huge demand offshore for Treasurys and [Ginnie Mae notes]. That’s why I think yields will fall.” The actual level of mortgage paper hitting the market also may be lower than the $35 billion capped level, so that could keep yields in check as lower supply won’t force issuers to provide higher yields as incentives. In fact, the level of MBS Fed holdings actually has risen about $18 billion in June, owing to lags in settlement dates, Whalen thinks the climate actually will help give bonds an edge at a time when the equity market is under pressure. “Equity managers have to get used to the idea that bonds could rally but stocks won’t,” he said. “Decoupling will be one of the more profound things that people in our business will have to deal with. What am I going to do with my asset allocation if I can’t assume that both equities and bonds will be up?” The market has struggled adapting to Fed communications in 2022, after the central bank pivoted from its stance in the previous two years that it would keep policy loose even if it saw inflation running above the Fed’s 2% inflation target. Under the current approach, officials said they plan on continuing to raise rates and running off the balance sheet until they see material signs that inflation has been broken. “Powell’s going to stick to his guns,” Whalen said of Fed Chair Jerome Powell. “I think he’s going to do exactly what he told us.”
© heardonwallstreet.com