There’s growing consternation among the analyst community that markets are insufficiently attentive to the risks posed by the Fed’s efforts to shrink its balance sheet.
Investors and traders will be forgiven for harboring an obsession with the path of policy rates. After all, many market participants haven’t personally witnessed the sort of aggressive hikes implemented in 2022 during their professional careers, and besides, central banks are keen to emphasize that rates, not balance sheet dynamics, are the primarily tool for addressing macro imbalances.
And yet, quantitative tightening feels conspicuously absent from the debate. BofA’s Savita Subramanian recently likened the situation to ignoring the elephant in the room.
In 2017, Janet Yellen famously likened balance sheet runoff to “watching paint dry,” but just over a year later, her former colleague and star-crossed successor was vexed when QT became the talk of the financial universe. In addition to being criticized in high profile Op-Eds from the likes of Stan Druckenmiller and Kevin Warsh, the Fed’s efforts to run down the balance sheet were derided by Donald Trump as “ridiculous” and “a killer,” among other things. Some of Trump’s criticism was retroactive, but some was contemporaneous, and although the funding squeeze that played out in September of 2019 illustrated that there is a breaking point, one could argue that the psychology around QT (exacerbated by endless press coverage) played a bigger role in pushing stock prices lower in late 2018 than any mechanical effects from the diminished liquidity impulse.
Fast forward to 2022, and so far, QT has indeed been like “watching paint dry.” That’s in part because media coverage seems sparse, but it’s also early innings. And there are other, more pressing matters — namely, a series of massive rate hikes and rampant inflation. The Fed put mechanisms and facilities in place to avert a repeat of the events which shook the repo market three years ago, but there’s no safeguard that makes risk assets immune to whatever the drag might be from balance sheet runoff.
Quantifying that drag is notoriously difficult, but a growing chorus of warnings suggests one main risk for markets is the step up in the pace of balance sheet runoff. “Might QT be the straw that breaks the market’s back?” SocGen’s Solomon Tadesse wondered, in a new note.
Tadesse, some readers may recall, uses a “monetary tightening to easing ratio” (MTE ratio) to differentiate between policy during the inflation containment regime of the 70s and 80s, and the growth-conscious policy bent that persisted during The Great Moderation and up to the pandemic. A ratio below 1.0 means (by definition) that policy trends easier over time.
As Tadesse reminded investors, the average degree of monetary tightening from 1984 through 2019 was about two thirds of the easing in the previous cycle. Had the Fed stuck to that in 2022, and in consideration of the rise in the shadow rate prior to the onset of rate hikes in March, the total additional tightening would’ve been just 300bps. “Our analysis suggests that if the Fed had given priority to growth rather than inflation-containment, it would need only a moderate tightening of 300bps, split between 75-100bps in policy rate hikes and the remainder from QT policies which would slash the balance sheet by up to $1.8 trillion,” Tadesse wrote.
The Fed, though, is no longer in the growth-protection business. In fact, Jerome Powell made it clear on Friday in Jackson Hole that officials are now in the business of engineering a slowdown in the service of what amounts to a single mandate: Inflation-fighting. If that entails a return to the MTE ratios which persisted pre-Great Moderation (figure on the left, below), it would mean delivering some 11.5% worth of tightening, using Tadesse’s framework. With 225bps already in the bag, that leaves 9.25% to go (figure on the right).
The QT share of the remaining tightening impulse could be around 450bps, according to SocGen.
Tadesse assumes every $100 billion of QT is roughly equivalent to 12bps of tightening, which means the Fed likely needs to shrink the balance sheet by almost $4 trillion, a push that would negate the majority of pandemic-era asset purchases.
The stars in the figure (on the left, above) show the “most likely” policy combinations under each regime. And, again, we’re now most assuredly in an inflation-containment regime.
“It was arguably not rate hikes back in 2018” that triggered the meltdown, but “accelerating QT in the background,” Tadesse wrote. “By the same token, it could be a ramp up in QT, this time on a larger scale to erode a much larger balance sheet, that surprise[s] markets.”
Qt is an unnecessary risk. Shorten balance sheet duration and reduce mortgage holdings relative to ust bonds if you must. Qt is an unknown and risky approach to tightening policy. If you keep the balance sheet size stable nominal gdp will grow into balance sheet size. Why chance this?
+1
The analysis is interesting, and maybe directionally useful, but the scenario where the Fed raises FF to 6-7% and does $4TR of QT is, I think, implausible.
The economy is a lot more financialized than in the 1970s-1980s. There is far more debt, leverage, and reliance on non-banks. I do not think anything like the 70s-80s degree of tightening will be required to squash demand and inflation. That’s not a computed conclusion, just a gut belief.
How much more tightening would it take to crash the SP500 to a 2 handle, tank house prices 30%, and drive UE up several points? Less than 925 bp, I think. If that happened, would demand still exceed supply in aggregate? Hard to imagine.
In 2018, the Fed was lending out to US banks almost nothing under ONRRP. Therefore, QT in 2018 was unquestionably removing liquidity from the US monetary system.
In 2022, the facts are different. The Fed’s balance sheet is $8.8T, however, ONRRP has increased from almost nothing in 2018 to $2.2T in 2022. This means that $2.2T of the $8.8T is being lended to banks, who need those Treasuries to meet banking reserve requirements.
What is not clear is whether any impact on overall liquidity resulting from a reduction in the Fed’s balance sheet via QT will be 1. negated by an offsetting reduction in ONRRP – meaning no net reduction in overall liquidity (because the banks are now purchasing the Treasuries that they previously borrowed under ONRRP); or 2. The QT is not offset by any reduction in ONRRP- meaning that QT will reduce liquidity in the US monetary system, as was occurring at the end of 2018.
It certainly seems possible that when banks think the rates have peaked, the banks will purchase Treasuries instead of choosing to borrow Treasuries. I am surprised that the ONRRP balance has stayed at this extremely high level through the rate increases the Fed has already made in 2022. The banks are paying a continually higher rate of interest to the Fed to borrow $2.2T under ONRRP. As soon as the banks choose to (maybe when they think rates have peaked?), they can purchase Treasuries (instead of borrowing the Treasuries) and earn interest income instead of paying to borrow under ONRRP.
As we seek perspective as to what the Fed will or won’t, can or can’t do, remember Volcker’s much vaunted effort to quell inflation pushed rates to over 20%! Lots of room to go. Me, while I like higher rates, I’d rather see some QT in the package because a two-pronged approach is likely to hurt consumer less. While inflation declines, whenever, it reduces the real cost of (consumer) debt so balance sheet activities that effectively tighten while leaving some room in the rate structure might be worth a try.
Wish I understood this one better.
Not a Fed wonk. Not keen on Fed nitty-gritty. I see the Fed’s bigger picture.
It’s not 2020. It’s 2022. I see the Fed taking account of its actions while facing down current economic challenges. I see the Fed assessing the current state of the economy and the impact of its actions in Q2 and Q3. The committee seems to be engaged and unified. And I see the Fed deciding how to move forward.
Not a Powell fan, but I’m grateful for how he framed his Jackson Hole comments on the economy last week. I’m glad the Fed and the economy do not require a dominating presence like Paul Volker, which would imply we have serious issues.
I wonder whether there is still a need for capitulation in the S&P. It fell below 3700 back in July. Looks like that might be the bottom. But with Fed actions, will recovery be only a matter of time and patience, as in other economic recoveries? It seems that might be the case.
I very much liked your reporting about comments from Soc. Gen’s Solomon Tadesse. I’ve seen a question or two about how QT might be useful under current economic circumstances. It was great to see Tadesse’s perspective. Very helpful.