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June 3, 2022

Warning: QT Starting Now

Michael J. Donoghue
Warning: QT Starting Now

The beginning of June 2022 marks the planned start of the Federal Reserve’s Quantitative Tightening (QT) program, a contractionary monetary policy tool intended to help curb hyperinflation in the US by reducing the money supply. Implemented in conjunction with the Federal Reserve’s plan to continue raising the federal funds rate by 50 basis point increments, this is a decisively hawkish agenda that will likely have an acute impact on the financial markets. Let’s explore further as we issue a warning: QT starting now.

A Brief History of QE/QT

QT is the ‘sibling’ program of Quantitative Easing (QE), its expansionary counterpart. QE is essentially a large-scale financial asset purchasing program that central banks utilize when their economy needs to be stimulated due to lower consumer spending, i.e., a mode of ‘money printing’. QE entails a central bank purchasing government bonds, mortgage-backed securities, and other assets to increase the money supply, creating new liquidity to encourage more lending, investment, and spending. QT has been described as the opposite of QE in the sense that it entails a subsequent central bank balance sheet reduction, effectively reducing the money supply and removing excess cash reserves to cool an overheated economy.

While the Bank of Japan is widely credited with pioneering QE in the early 2000s, the expansionary strategy was popularized by central banks around the world during the 2008 financial crisis. It saw even wider use in early 2020 onward, in attempts to combat global COVID-era economic catastrophe. However, despite its worldwide popularity, both QE and QT remain in their infancy, and are thus regarded as somewhat experimental programs.

Differences from QT in 2017

The last time that the Federal Reserve implemented QT was to reduce the size of its balance sheet back in 2017, after it had built up a (then) unprecedented $4.5 trillion portfolio. They began letting their securities mature gradually, starting around $10 billion per month and eventually quintupling that pace over the next few years. These measures, in conjunction with periodic interest rate hikes, correlated with relatively stable growth in the US economy.

Several variables have changed this time around: first, the rate hike agenda is far more aggressive than it was five years ago: Chairman Powell has made it clear that 50 basis point hikes are on the menu for now, a departure from the more modest 25 bp hikes of the past. The timeline for hikes is more rushed than in 2017 as well. Second, this iteration of QT’s pace is quicker as well, with security maturation caps expected to near $100 billion per month by the end of this year. This seemingly corresponds with the Fed’s balance sheet being just under $9 trillion this time, near double that in 2017. Third, the US economy does not seem to be weathering this transition well, with a 1.5% contraction in Q1 GDP and a sharp drop in value for the US stock market (in part due to supply chain issues, ubiquitous hyperinflation, and volatile geopolitical tensions).

Possible Outcomes

The truth is, we are effectively in uncharted waters, so it is virtually impossible to know what consequences QT (or QE, belatedly) will ultimately have. However, considering our limited experience with it, one of two outcomes seems most likely: 1) QT will have an apparently mild/neutral effect on the US economy, to the point that its shrinking of the money supply is nearly imperceptible for buyers and sellers. Considering its historical correlation with economic growth, there is even a chance it could be seen as a slight bullish fundamental catalyst for the US stock market, a harbinger of the end of hyperinflation risks and woes.

2) Aggressive QT, concomitantly with rapid consecutive 50 bp rate hikes, will contribute to a recipe for recession in the US, encouraging investors to shy away from riskier securities in favor of government bonds, USD, and other safe haven assets. While this scenario seems most likely to me, today’s higher-than-expected NFP numbers showcase a resilient US economy and may have given the Fed more breathing room to pursue this hawkish agenda without recession looming. We will have to patiently keep tabs on other indicators going forward to monitor this.

Key Takeaways

  • Quantitative Easing (QE) and Quantitative Tightening (QT) are a pair of expansionary and contractionary monetary policies that central banks can use to effectively increase and decrease their economy’s money supply, respectively.
  • The Federal Reserve is beginning a QT program this month, where they will begin letting their securities mature, shrinking their nearly $9 trillion balance sheet and rapidly reducing the money supply in the US.
  • Though QE and QT are still new and rather experimental globally, a lesser version of QT was implemented in the US in 2017, and the US economy handled it well.
  • I am anticipating the new QT program to either have a mild/neutral effect on the US economy like the program in 2017, or to eventually help usher in a recession while investors flock to government bonds, USD, and other safe haven assets.

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