In recent conversations with our accounts, we have been hearing more concern about the second round of quantitative tightening (QT2), which starts next month.
Monetary Policy I: The Big Runoff.
The first round of quantitative tightening (QT1) lasted from October 1, 2017 to July 31, 2019 (Fig. 1).
The fear is that QT2 will push interest rates even higher than would be the case if the Fed focused only on raising the federal funds rate while replacing maturing securities on its balance sheet. By letting maturing securities run off, there could be more upward pressure on interest rates as the fixed-income markets are forced to finance more Treasury and agency debt as well as mortgage-backed securities. In previous tightening cycles, with the exception of QT1, the Fed raised the federal funds rate without running off its balance sheet. This time, such rate hikes could be amplified by QT2.
Indeed, the rapid rise in interest rates so far this year may very well have been exacerbated by the Fed’s stated intention to start QT2 during the second half of this year. On January 5, the Fed released the minutes of the December 14-15, 2021 FOMC meeting revealing that the committee’s members were turning much more hawkish and were seriously discussing quantitative tightening. Indeed, there was a section in the minutes focusing just on “Principles for Reducing the Size of the Balance Sheet.”
The consequences of the Fed’s pivot from its ultra-easy monetary policy since 2008 to a tightening monetary stance are still ongoing and not in a good way for stocks and bonds. The 2-year US Treasury yield has soared from 0.73% at the start of this year to 2.61% at the end of last week (Fig. 2). The 10-year US Treasury yield has jumped from 1.52% to 2.93% over this same period. The S&P 500 dropped 16.1% from its record high on January 3 (just before the minutes were released on January 5) through Friday’s close, led by a 21% plunge in its forward P/E from 21.5 to 17.0 over this period (Fig. 3 and Fig. 4).
The concern is that because the Fed has fallen well behind the inflation curve, Fed officials now are about to err on the side of haste—tightening too much too fast with a monetary cocktail of rising rates and a declining balance sheet. That may very well bring inflation down, but with a hard landing for the economy too. That’s not our expectation, but it is a widespread fear. We continue to put the odds of a hard landing/recession at 30%.
Monetary Policy II: The Runoff Plan.
Following the May 3-4 meeting of the FOMC, the Fed issued a press release titled “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet.” It noted that “all Committee participants agreed to the following plans for significantly reducing the Federal Reserve’s securities holdings.” Here are the details:
(1) First three months of QT. During June through August, the Fed will reduce its balance sheet by running off maturing securities, dropping its holdings of Treasury securities by $30.0 billion per month and its holdings of agency debt and mortgage-backed securities by $17.5 billion per month. So that’s a decline of $142.5 billion over the next three months.
(2) QT after August. Starting in September, the runoff will be set at $60 billion for Treasury holdings and $35 billion for agency debt and mortgage-backed securities. That’s $95 billion per month and $1.14 trillion over a 12-month period (Fig. 5).
(3) No terminal amount or date. There’s no amount set or termination date specified for the QT2. The press release simply states that “the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.” Assuming that QT2 is terminated at the end of 2024, the Fed’s holdings of securities would decline by $2.8 trillion, to $5.7 trillion from $8.5 trillion, in May.