The Fed Begins Quantitative Tightening: What It Means for Financial Markets

The Federal Reserve’s nearly $9 trillion asset portfolio is set to be trimmed from Wednesday, part of a process intended to complement rate hikes and bolster the central bank’s fight against the ‘inflation.

While the precise impact of “quantitative tightening” on financial markets is still up for debate, analysts at the Wells Fargo Investment Institute and Capital Economics agree that it is likely to produce another headwind for investors. shares. And that’s a dilemma for investors facing multiple risks to their portfolios right now, as government bonds sold off and stocks suffered losses on Tuesday.

In a nutshell, “quantitative tightening” is the opposite of “quantitative easing”: it’s essentially a way to reduce the money supply floating around in the economy and, according to some, helps to increase interest rate hikes. predictably – however, by the way much remains unclear. And it can be anything but as boring as “watching the paint dry,” as Janet Yellen described it when she was Fed chair in 2017 — the last time the central bank started a similar process.

The main impact of QT is in the financial markets: it is seen as likely to drive up real or inflation-adjusted yields, making equities a little less attractive. And that should put upward pressure on Treasury term premia, or the compensation investors need to bear interest rate risk over the life of a bond.

Moreover, the quantitative tightening comes at a time when investors are already in a bad mood: optimism about the short-term direction of the stock market is below 20% for the fourth time in seven weeks, according to the results of a confidence survey. released Thursday by the American Association of Individual Investors. Meanwhile, Chairman Joe Biden met with Fed Chairman Jerome Powell on Tuesday afternoon to discuss inflation, the topic that worries many investors.

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“I don’t think we know the impacts of QT yet, especially since we haven’t reduced the balance sheet much in history,” said Dan Eye, chief investment officer of Fort Pitt Capital Group, based in Fort Pitt Capital Group. Pittsburgh. “But it’s a safe bet to say that it takes liquidity out of the market, and it’s reasonable to think that when liquidity is taken out, it affects valuation multiples to some degree.”

Starting Wednesday, the Fed will begin reducing its holdings of Treasuries, agency debt and agency mortgage-backed securities by a combined $47.5 billion a month for the three first months. After that, the total amount to be cut stands at $95 billion per month, with policymakers ready to adjust their approach as the economy and financial markets evolve.

The reduction will occur as maturing securities exit the Fed’s portfolio and the proceeds are no longer reinvested. Starting in September, rolloffs will occur at a “considerably faster and more aggressive” pace than the process that began in 2017, according to the Wells Fargo Investment Institute.

According to the institute’s calculations, the Fed’s balance sheet could shrink by nearly $1.5 trillion by the end of 2023, bringing it down to around $7.5 trillion. And if QT continues as expected, “this $1.5 trillion reduction in the balance sheet could equate to an additional 75 to 100 basis points of tightening” at a time when the fed funds rate is expected to be around 3, 25% to 3.5%, the institute said in a note this month.

The target range for the federal funds rate is currently between 0.75% and 1%.

Sources: Federal Reserve, Bloomberg, Wells Fargo Investment Institute. Data as of April 29.

“Quantitative tightening could add upward pressure on real yields,” the institute said. “Along with other forms of tightening in financial conditions, this represents a new headwind for risk assets.”

Andrew Hunter, senior US economist at Capital Economics, said “we expect the Fed to reduce its assets by more than $3 trillion over the next two years, enough to bring the balance sheet back in line with its pre-pandemic level. as a share of GDP. While this shouldn’t have a major impact on the economy, the Fed could halt QT prematurely if economic conditions “deteriorate”, he said.

“The main impact will come indirectly via effects on financial conditions, with QT putting upward pressure on Treasury term premia which, alongside a further slowdown in economic growth, will add to the headwinds facing the stock market. “Hunter said in a note. The main uncertainty is the duration of the Fed’s meltdown, he said.

All three major U.S. stock indexes ended lower on Tuesday, with Dow Industrials DJIA,
slipping 0.7%, the S&P 500 SPX,
down 0.6%, and the Nasdaq Composite COMP,
by 0.4%. Meanwhile, Treasury reports TY00,
were higher as bonds were sold across the board.