Full Speed Ahead Quantative Tightening

The public completely misunderstands quantitative tightening (QT). Tightening doesn't mean the end of accommodating monetary policy. The public sees it as a constant and immediate liquidity drain. On the contrary, when central banks are tightening, they are still adding to the system, but at a much slower pace than before. June 1st was the first official day that QT started, the value of the balance sheet was 8.8 trillion dollars. On that day the Federal Reserve of America started selling $30 billion of Treasury securities and $17.5 billion of mortgage-backed securities, intending to increase this to 60 billion of Treasury securities and 35 billion of mortgage-backed securities in September. Stocks and Crypto closed red on June 1st, and everybody thought it was over.

There are two ways for the Federal Reserve to approach QT, a passive and active approach.

Passive Balance sheet reduction

When a central bank commits to a passive approach, they don't reinvest the assets as they mature. This is better known as the balance sheet runoff. Depending on the structure and maturity of the central banks’ holdings, this is a relatively passive approach and a slower way to reduce holdings.

I have an excellent analogy for the confused readers where this made no sense. We have Tim, and Tim has gained some weight, and he decides to shed some pounds. The passive approach is equivalent to Tim going on a diet and not ‘reinvesting’ his biscuit consumption each day. Over time, Tim’s caloric deficit will see weight loss.

From June till August, the Federal Reserve has acted quite passively to reduce its balance sheet.

The earliest retrievable value from the Federal Reserve balance sheet in December is $8.5 trillion of assets; looking at the chart mentioned above, this isn't a straight line down; it is a bumpy chart with lower highs and lower lows. What's important to see is that it's trending lower. If we do some quick math, in June, July, August, September, October, and November, the Federal Reserve had planned to sell a total of $427.5 billion in assets. The Fed’s balance sheet value should be closer to $8.4 trillion in assets. When we look at the chart mentioned above, the total value of the assets on the balance sheet is much more relative to $ 8.5 trillion in assets. This is why there is a passive approach to the balance sheet runoff; the Federal Reserve can't sell that many assets because of liquidity constraints in the market.

Active Balance sheet reduction

This is the aggressive approach. The Federal Reserve will be actively selling assets from the balance sheet and sucking liquidity out of the private sector. Looking at the weight loss analogy, this is when Tim gets serious about weight loss. He joins the gym, hires a nutritionist and trainer, and starts researching anabolic cycles.

Tim means business.

In its simplest form, the aggressive approach is seen as liquidity withdrawal. It is usually seen as bad news for stocks and risky investments because it creates capital scarcity relative to the prior status quo. Capital becoming less plentiful means more competition for a shrinking liquidity pool.

Why is QT dire for asset prices?

As the Federal Reserve’s QT program sucks liquidity from the market, assets have to 'compete' for a shrinking pool of capital. Government debt issuance plays a role too. Take US treasuries as an example. Governments must issue debt to pay government employees, meet their budget commitments, pay social security, etc. Suppose the Government is issuing (selling) debt simultaneously as the Fed is selling debt. In that case, they're both taking liquidity from the private sector and reducing the pool of investible capital. And for various regulatory reasons, the banking system must absorb the government issuance to ensure they meet their quota of High-Quality Liquid Assets (HQLA). All in All, this means that there's less liquidity left to chuck in fun things like meme stocks and crypto.

In the recent Fed minutes, they mentioned they intend to drain the RRP (the reverse repo program) and whether that will involve any regulatory changes to the SLR (Supplementary Leverage Ratios).

“A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is a transaction in which a security holder sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction”.

Well, the Federal Reserve uses reverse repos to conduct monetary policy. The Repo market allows financial institutions with a lot of securities (The Fed and their large balance sheet) to borrow funds from parties with spare cash, such as money market mutual funds, to earn a small return on cash with a minimum because the securities are often US treasury bonds and are seen as the safest asset in the world.

A couple of months ago, US banks were pushing consumers not to deposit funds with the bank themselves but with the bank's money market mutual funds (completely different entities from the bank and have access to the Repo market). This means that reserves that would otherwise not pose a problem for monetary policy rate implementation were being pushed out into the money market mutual funds complex because of SLR ratios. Banks have tried to hold the SLR ratio at its perfect amount by pushing more money into their money market mutual funds to access the RRP. The challenge the Fed now faces is how they plan to shift the 2.2 Trillion dollars in the RRP back to the bond market to soak up the FED balance sheet runoff without easing financial conditions.

What does an Active QT mean for Risk on Assets?

History does not very often repeat itself, but sometimes it does rhyme.

The first time the Fed ever started QT was in October 2017, but (similar to this time) meaningful balance sheet reduction took a while to kick in. The considerable reduction in the size of the Fed’s balance sheet started in the summer of 2018, and stocks did not crash, but they traded well that summer before crashing in Q4. The peak was September 21, 2018.

So, I suppose the Fed’s liquidity reduction acceleration should be a yellow light for equity investors again into Q4. Still, the relationship is murky, and the timing is debatable, so it’s more like a reason to lean cautious and protect your capital.

Whether history repeats, rhymes, or something else is still an open question. However, the idea is that QT is somehow 'priced in' (Yes, some people are saying this, but nothing is ever priced in).

There's still a lot of uncertainty over how the events in the coming months will work in practice, so what is there for markets to price in?

It's still early days. Don't mistake the current rally for QT as being priced in. It's just about to ramp up. Eventually, the liquidity withdrawal/redirection and higher rates will likely take a toll on crypto, especially if the contagion keeps making companies insolvent.

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