Quantitative Tightening, or Plateauing?

By:

Chief Strategist at Interactive Brokers

Thus far this year, the Federal Reserve has been aggressive about utilizing interest rate hikes to combat inflation.  From February through June we saw the Fed Funds target jump from 0%-025% to 1.5%-1.75%, with futures markets currently implying another hike of 75 basis points later this month.  We can question whether the Fed’s response was belated, but we can’t question its current sincerity.

Yet when we consider that inflation is basically too much money chasing too few goods, it is important to note that interest rate hikes address the price of money rather than the amount of available money in the system.  (Central banks can to almost nothing to increase the amount of goods.)  Of course if we raise the price of money via interest rate hikes it will dampen the availability of credit, but the more direct path toward restricting the money supply would be through quantitative tightening (QT). 

The Fed has indeed begun to reduce the size of the securities held on its balance sheet by $47.5 billion per month.  They do this by opting not to reinvest all the proceeds of maturing Treasury debt that they hold.  We can see from the graph below that its effect on the absolute size of the balance sheet is quite minimal.  Even when increased to a promised $95 billion per month in September, it will still be a relatively glacial pace of shrinkage relative to the pace at which the balance sheet grew during the two-year period starting in March 2020.

Securities held on the Fed balance sheet 2021-2022

Sources: Federal Reserve H.4.1 reports, Interactive Brokers

While we see that the balance sheet has plateaued and has begun to decline modestly in recent weeks – and the moving averages have begun to turn lower – it will clearly take a few months just for the size of the Fed’s securities holdings to revert to their size from the start of the year. 

Aggressive rate hikes are a very visible way for the central banks to signal that they are aggressively fighting inflation.  They receive much attention in the media, and thus the general public tends to see the effort, if not immediate results.   Other than a few financial nerds like me – and hopefully you, dear reader – there is scant attention paid to the size of the Fed’s balance sheet.  Yet there must be some reason why the Fed is seemingly so reticent to use a potentially powerful tool at their disposal. 

The only reason I can come up with is that they are deathly afraid of putting QT to full use.  If we can attribute a good portion of the recent rise in asset prices to the amount of money created by quantitative easing (QE), then we need to be concerned about what could happen to asset prices if that pattern reverses.  We have a highly levered economy, and even though rates adversely impact the ability for consumers and business to access credit, the effect of rate hikes are mostly felt when old debt needs to be refinanced or new debt needs to be borrowed.  Those who trade on margin feel the impact of rate hikes relatively quickly, but those with existing fixed rate mortgages don’t necessarily feel it at all.  Higher rates generally do not choke off the ability of credit-worthy borrowers to access credit.  A rapidly shrinking balance sheet could.

In the (too busy) chart below, pay attention to the bumps in the magenta line (the Fed balance sheet) in mid-2013 and late-2019.  In April 2013, then-Chair Bernanke caused a so-called “taper tantrum” when he said that the Fed would consider shrinking the size of its balance sheet.  Rates spiked (green line), and the Fed responded instead with more QE, rather than the promised QT. 

20-Year Monthly Data

S&P 500 Index (white/blue, log scale, far right scale), Securities Held on the Federal Reserve Balance Sheet (magenta, near right scale), 10-Year US Treasury Yield (green, left scale), Fed Funds Target Rate (orange, left), CPI Year-Over-Year Change (purple, left)

20-year monthly data S&P 500 Index (white/blue, log scale, far right scale), Securities Held on the Federal Reserve Balance Sheet (magenta, near right scale), 10-Year US Treasury Yield (green, left scale), Fed Funds Target Rate (orange, left), CPI Year-Over-Year Change (purple, left)

Source: Bloomberg

In 2018, the Fed began shrinking its balance sheet and raising rates to fight inflation (purple line) and to give itself more ammunition if a crisis developed.  We had a bear market in late 2018 as both effects kicked in, though stocks stopped falling when the Fed announced that its December 2018 hike would be its last. Stocks ignored the shrinking balance sheet for much of 2019, and then kicked into high gear when the roughly $600 billion drop in the size of the balance sheet led to a repo crisis among major banks.  Stocks eventually jumped when the Fed responded by reversing its balance sheet reduction, a jump that was only halted – albeit temporarily – by the Covid crisis.

The evidence for stock traders is this: major equity indices have shown that they are able to largely ignore QT.  But the bouts of QT have been fleeting, and the scope of QE that is subject to reversal has never been larger.  Nor has the level of inflation been higher in over 20 years.  So far investors can focus on rate hikes instead of QT, but QT remains a potential stumbling block later this year, when it kicks in during a seasonally difficult period that includes the mid-term elections.

Disclosure: Interactive Brokers

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