Quantitative tightening could be more consequential than the June CPI print. Let’s keep an eye on what is really important
I have been waiting for the FOMC’s May meeting minutes to get a better understanding of not only their future interest rate hikes but also their quantitative tightening plans. The former has been well-signalled by Chair Powell and other board members. The latter has been more of a mystery, even though it has greater potential of causing market volatility.
Quantitative tightening (QT)
QT is when the Feds stop buying bonds to add liquidity to the market and in fact, starts selling bonds they already hold on their balance sheet. They currently own about $9T in bonds.
For the longest time, the US Fed was the largest buyer (often the only buyer) of US treasury bonds and mortgage-backed securities (MBS). Through their purchases, they supplied new monies to the markets, kept bond prices elevated and interest rates low. When bonds are bid up leading to their purchase, their interest yields stay low and stocks get a boost. This dovish, accommodative Fed policy, called Quantitative Easing (QE) led to a multi-year bull market and has now been halted. The upcoming selling of Fed bond assets could add to the nervousness in the bond markets, leading to some chaotic price action.
The plan, as we now know it, is that starting June 1st, 2022, the US Fed will start selling up to $60B of Treasury securities and up to $35B of MBS per month. The key question is who is going to step in to buy these bonds? We do not know…
We also don’t know for how long they will keep selling their bond assets, presumably well into 2023. They will also let expiring bonds roll off the balance sheet over time and will not replace them. Analysts estimate a total reduction of about $2-3T of bond assets when it’s all said and done, at a rate of over $1T per year.
Interest rate hikes
The FOMC also confirmed that they intend to raise rates by 0.5% in June and again in July. This will be followed by a periodic review of economic data from Aug onwards and could result in additional raises of up to 1.25% by mid-2023…presumably 0.25% at a time.
So why do I care about all this boring FOMC stuff?
Because if bond markets do not perform smoothly when QT starts, we could see a significant side-impact to stock markets.
Growth investors have been hoping for a relief rally, however this has not happened. Stocks don’t seem to be able to string together more than one day of green, meanwhile they have no problem giving us multi-day streaks of red.
Until we get a better feel for how the bond markets perform, come June 1st, we will continue to be in this 1-step forward, 3-steps backward market.