Fed’s quantitative tightening is coming: what it means for markets

The Fed’s nearly $9 trillion portfolio will begin shrinking on Wednesday in an effort to supplement interest rate hikes and support the central bank’s fight against inflation.

While the exact impact of “quantitative tightening” on financial markets is still up for debate, analysts at Wells Fargo Investment Institute and Capital Economics agree that it could be another headwind for stocks. It’s a dilemma for investors currently facing multiple risks to their portfolios, as stocks pared losses on Tuesday as government bonds sold off.

In short, “quantitative tightening” is the opposite of “quantitative easing”: it’s basically a method of reducing the supply of money flowing through the economy, and some say it helps to increase interest rate hikes in a predictable way— —However, through how many things are unclear.it may become meaningless “Watch the paint dry,” As Janet Yellen described it when she was Fed chair in 2017 – this is the last time the Fed will initiate a similar process.

The main impact of QT is in financial markets: it is thought to be likely to push up real or inflation-adjusted yields, which in turn makes stocks less attractive.it should be right Treasury term premiumor the compensation investors need to take on interest rate risk over the life of the bond.

What’s more, quantitative tightening comes at a time when investor sentiment is already pretty bad: Optimism about the stock market’s short-term direction is below 20% for the fourth time in seven weeks, according to a study. sentiment survey Released Thursday by the American Association of Individual Investors.Meanwhile, President Joe Biden Meet Federal Reserve Chairman Jerome Powell spoke on inflation Tuesday afternoon, the topic of top concern for many investors.

read: Biden pledges to uphold central bank independence in meeting with Fed Chair Powell and Biden’s inflation meeting with Fed’s Powell seen as ‘politically good for the president’

“I don’t think we know the impact of QT at this point, especially since we haven’t historically done much shrinking of the balance sheet,” said Dan Eye, chief investment officer at Pittsburgh-based Fort Pitt Capital Group. “But it’s for sure. That said, it would take liquidity out of the market, and it is reasonable to assume that as liquidity is taken out, it will affect valuation multiples to some extent.”

Starting Wednesday, the Fed will begin reducing its holdings of Treasuries, agency debt and agency mortgage-backed securities by a combined $47.5 billion each month for the first three months. After that, monthly reductions total as much as $95 billion, and policymakers prepare to adjust their approach as the economy and financial markets evolve.

This reduction will occur as maturing securities roll out of the Fed’s portfolio and earnings are no longer reinvested. As of September, the price cuts will come at a “much faster and more aggressive” pace than the process that began in 2017, according to the Wells Fargo Investment Institute.

The Fed’s balance sheet could shrink by nearly $1.5 trillion to around $7.5 trillion by the end of 2023, according to the institute’s calculations. If the QT continues as expected, “a $1.5 trillion reduction in the balance sheet could equate to another 75 to 100 basis points of tightening” at a time when the federal funds rate is expected to be around 3.25% to 3.5%, the institute said this month. said in a report.

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

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

“Quantitative tightening is likely to increase upward pressure on real yields,” the institute said. “Together with other forms of tightening of financial conditions, this is a further headwind for risk assets.”

Andrew Hunter, senior U.S. economist at Capital Economics, said: “We expect the Fed to reduce its holdings by more than $3 trillion over the next few years, enough to return its balance sheet to pre-pandemic levels. As a percentage of GDP .” He said that while this shouldn’t have a major impact on the economy, the Fed could stop QT prematurely if economic conditions “worse”.

“The primary impact will be indirect from the impact on financial conditions, with QT putting upward pressure on the Treasury term premium, which, combined with a further slowdown in economic growth, will add to the headwinds facing equities,” Hunter said in a note. The key uncertainty, he said, is how long the Fed’s bankruptcy will last.

On Tuesday, the three major U.S. stock indexes closed lower, with the Dow, Dow,
-0.67%
The S&P 500 fell 0.7%,
-0.63%
Down 0.6%, the Nasdaq Composite,
-0.41%
Down 0.4%. Meanwhile, Treasury yields moved higher as bonds sold off across the board.