The Great Unwind
Updated: Jan 16
This article was written by Richard Horswill; all views and opinions expressed are strictly his own.
As of 1st June 2022 the Federal Reserve initiated quantitative tightening (QT). This is principally a reversal in policy from the previous quantitative easing (QE) that has been used in order to place a somewhat psychological ceiling in the treasury market whereby the Central bank was a consistent buyer of bonds helping to suppress yields and attempt to spur economic growth using zero interest rate policy. Thus, the new policy is now being used in an attempt to tighten financial conditions alongside the usual interest rate tool by raising rates to create the opposite conditions whereby demand is suppressed leading to an easing in the current inflationary environment. This article attempts to provide clarity on the actual mechanisms of the policies and the possible unintended outcome that may result.
The Federal Reserve currently has an $8.9 trillion balance sheet. This is made up of US treasury debt and mortgage backed securities. This has been achieved through the use of Quantitative easing, whereby the Central bank has “taken” the securities from various institutions, banks, insurance companies and the like. The trajectory of the reduction in the balance sheet equates to a total of $47.5 billion per month (the first $15 billion to mature on the 15th June) up until September whereby it rises to $95 billion per month. At this point it is important to outline how both QE & QT work.
Commercial banks take in customer deposits; they can then use the funds either to lend against them to other customers or if market conditions suggest lending may be too risky or there aren’t enough borrowers they can buy treasuries or mortgage backed securities (MBS). If they do the latter they create a “bank reserve.” When the Central bank comes along with their QE policy they request that they “take” the treasury or MBS and they effectively swop it for a “Reserve asset” which provides a balance sheet entry showing that the bank still has a claim to the security on their balance sheet. No monies change hands or extra monies are created however the bank can still lend against the collateral of the Reserve asset. It is the Central banks balance sheet swelling that suggests they are somehow printing money; however this is a falsehood as they cannot print money.
When the Central bank starts to reverse the policy initiating QT they allow the securities to run off the balance sheet as they mature. This provides the obligation to the issuer of the bond to pay the par value of the security to the holder of the bond. Thus in the case of treasury securities, the US treasury has to pay the Federal Reserve the par value of the bond at which point the Fed has to swop the cash provided by the treasury with the Reserve asset claim held by the bank. Thus the bank ends up with the cash which is effectively back to square one as a customer deposit. From this point the bank/banks have, after the June 22 QT process, $47.5 billion to either lend out or use to repurchase securities, and this dilemma will persist while the tightening cycle remains in place.
Bearing in mind the current negative market psychology caused by rates rising particularly at the front end of the curve, driven by the monetary tightening via the “minimal” interest rate increases, but mainly by the strong signals from the Fed of more to come, it is more likely the banks will be buying treasuries or MBS. The banks will have full control over what they buy, thus in order to help their primary business of lending they will likely want longer dated rates to fall to protect their mortgage business hence they are likely to buy the longer duration bonds further along the yield curve which will help to cap and ultimately drive interest rates lower. This completely undermines the actions that the Federal Reserve is attempting to enact, to suppress inflation by raising rates, and thus provides an unintended outcome that the market is not anticipating. Volatility is likely to be a consequence of the mixed market signals. Expectations of higher interest rates and attempts to take them there could therefore be wrong, and in many ways this makes absolute sense, as higher interest rates cannot tackle supply deficits driven by pandemic and war anyway. This has also been indicated in the yield curve inversions as market participants are suggesting they do not consider the actions of the Federal Reserve to be correct.
Lower rates would spur borrowing, monetary growth would assist the populace to afford the higher prices whilst the supply chain mends. The inflationary consequences of high energy costs look likely to persist but artificially tightening money supply will lead us into stagflation as an overly aggressive Fed will initiate demand destruction and ultimately recession. Too much money is not the current problem, however a lack of money will become the problem as Central banks attempt to control the wrong type of inflation with the wrong policy tool driven by political expediency. The market will ultimately decide the fate of interest rates, not the central banks. In the immortal words of Margaret Thatcher “There is no way in which one can buck the market.” Time will tell.