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MARKET EXTRA




FED TO BEGIN QUANTITATIVE TIGHTENING: WHAT THAT MEANS FOR FINANCIAL MARKETS

Last Updated: June 1, 2022 at 6:34 a.m. ET First Published: May 31, 2022 at 3:09
p.m. ET
By

VIVIEN LOU CHEN

  comments


QT ‘MAY ADD TO UPWARD PRESSURE ON REAL YIELDS’: WELLS FARGO INVESTMENT INSTITUTE

FED CHAIR JEROME POWELL.

Olivier Douliery/Agence France-Presse/Getty Images
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COMP
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The Federal Reserve’s almost $9 trillion portfolio is about to be reduced
starting on Wednesday, in a process intended to supplement rate hikes and
buttress the central bank’s fight against inflation.

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

In a nutshell, “quantitative tightening” is the opposite of “quantitative
easing”: It’s basically a way to reduce the money supply floating around in the
economy and, some say, helps to augment rate hikes in a predictable manner —
though, by how much remains unclear. And it may turn out to be anything but as
dull as “watching paint dry,” as Janet Yellen described it when she was Fed
chair in 2017 — the last time when the central bank initiated a similar process.

QT’s main impact is in the financial markets: It’s seen as likely to drive up
real or inflation-adjusted yields, which in turn makes stocks somewhat less
attractive. And it should put upward pressure on Treasury term premia, or the
compensation investors need for bearing interest-rate risks over the life of a
bond.

What’s more, quantitative tightening comes at a time when investors are already
in a pretty foul 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 sentiment survey released Thursday by the American Association of
Individual Investors. Meanwhile, President Joe Biden met with Fed Chairman
Jerome Powell Tuesday afternoon to address inflation, the topic at the forefront
of many investors’ minds.

Read: Biden pledges adherence to central-bank independence as he meets with Fed
chief Powell and Biden’s meeting on inflation with Fed’s Powell seen as ‘good
for the president politically’

“I don’t think we know the impacts of QT just yet, especially since we haven’t
done this slimming down of the balance sheet much in history,” said Dan Eye,
chief investment officer of Pittsburgh-based Fort Pitt Capital Group. ”But it’s
a safe bet to say that it pulls liquidity out of the market, and it’s reasonable
to think that as liquidity is pulled out, it affects multiples in valuations to
some degree.”

Starting on Wednesday, the Fed will begin reducing its holdings of Treasury
securities, agency debt, and agency mortgage-backed securities by a combined
$47.5 billion per month for the first three months. After this, the total amount
to be reduced goes up to $95 billion a month, with policy makers prepared to
adjust their approach as the economy and financial markets evolve.

The reduction will occur as maturing securities roll off the Fed’s portfolio and
proceeds are no longer reinvested. As of September, the rolloffs will be
occurring at “a substantially faster and more aggressive” pace than the process
which started in 2017, according to the Wells Fargo Investment Institute.

By the institute’s calculations, the Fed’s balance sheet could shrink by almost
$1.5 trillion by the end of 2023, taking it down to around $7.5 trillion. And if
QT continues as expected, “this $1.5 trillion reduction in the balance sheet
could be equivalent to another 75 – 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 of the fed-funds rate is currently between 0.75% and 1%.




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

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

Andrew Hunter, a senior U.S. economist at Capital Economics, said that “we
expect the Fed to reduce its asset holdings by more than $3 trillion over the
next couple of years, enough to bring the balance sheet back in line with its
prepandemic level as a share of GDP.” Though that shouldn’t have a major impact
on the economy, the Fed might stop QT prematurely if economic conditions “sour,”
he said.

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

On Tuesday, all three major U.S. stock indexes finished lower, with Dow
industrials DJIA, -0.67% sliding 0.7%, the S&P 500 SPX, -0.63% down 0.6%, and
the Nasdaq Composite COMP, -0.41% off by 0.4%. Meanwhile, Treasury yields were
higher as bonds sold off across the board.









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U.S. STOCKS END LOWER TUESDAY AS BIDEN, POWELL MEET ON INFLATION; DOW, S&P EKE
OUT GAINS IN MAY

U.S. stocks close lower Tuesday after a three-day break.


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 * Barron's: Stock Market Today: The Dow Is Slipping, Oil Prices Are Rising, and
   Alibaba Is Jumping


ABOUT THE AUTHOR

Vivien Lou Chen


Vivien Lou Chen is a Markets Reporter for MarketWatch. You can follow her on
Twitter @vivienlouchen.



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