Is the End Well-Nigh for Quantitative Tightening?

During the pandemic, the Fed resumed its quantitative easing (QE) program. As economic conditions normalized, it turned to quantitative tightening (QT) in the summer of 2022. What are the implications of the upcoming winding down—or tapering—of QT?

Having peaked at US$9.0 trillion in April 2022, the US Fed’s balance sheet stood at US$7.8 trillion last December. This is still double the level that prevailed in the summer of 2019, suggesting there is a long way to go before the balance sheet normalizes. Why then is the Fed considering slowing the pace of run-offs? We outline the rationale and investment implications below.

There are two key elements to the balance sheet policy discussion:

1. The desired end point of QT
2. The desired path – speed of QT and final balance sheet composition

The Desired End Point of QT

Multiple indicators suggest there remains excess liquidity in the financial system. For one, the reverse repo facility still holds about US$600 billion – a normal state would see that balance back to zero. Secondly, bank reserves as a share of nominal GDP remain at healthy levels even though they have moderated noticeably from the pandemic-era records (Figure 1).
 

At the same time, while the Fed’s intent is to eliminate excess reserves, the desire is to maintain an ample reserves environment. There are no clear-cut estimates for what that level actually is, but—just as Chair Jerome Powell stated about the neutral policy rate—it, too, can be known “by its works.”

While an unusual confluence of factors resulted in the acute stress episode experienced in the repo market in 2019, one interpretation is that by that point reserves likely had become scarce. In the summer of 2019, bank reserves had fallen to below 7% of nominal GDP. All else being equal, one could argue that a cushion of 1-2 percentage points may therefore identify the lower estimate of an ample reserve environment (Figure 2).
 

Some Important Differences Compared With 2019

There are some important differences between where the economy stands today versus where it was back in 2019. For one, following the aggressive monetary tightening cycle, US banks today sit on massive unrealized losses linked to their fixed income portfolios. A more conservative balance sheet management and an increased preference for reserves may be the net result (Figure 3).
 

Another difference is that US debt has surged by over 45% since January 1, 2020. Hence, despite the fact that the Fed still holds almost double the amount of Treasury securities it did at the prior peak in 2014-17, those holdings represent roughly the same share of outstanding securities as in 2015.

With momentum for some tax relief building in Congress this election year, there may be more debt issuance in 2024 than previously anticipated, further advising caution on run-off speed.

The Desired Path of QT

If the Fed’s balance sheet end goal is indeed in sight, the speed with which run-offs occur should naturally slow. One could describe this as the “work zone” for QT. Similar to the calculation on interest rates, when the Federal Open Market Committee (FOMC) felt that the Fed funds rate was far from where it needed it to be, they hiked in large increments. As they got closer to the desired level, rate hikes moderated in magnitude before ceasing altogether.

Similarly, before QT ends, it should slow. And if it needs to slow within a few months, the FOMC would want to signal that ahead of time, as they are doing now.

Timing of Tapering and Composition of Balance sheet

Interest rates and balance sheet are complementary tools that work in tandem in achieving the desired monetary policy setting, although their area of direct impact differs. There has been a concerted effort from FOMC members to divorce taper action from rates policy, but that can only go so far. To the extent that the FOMC feels policy needs to remain tight to wring out remaining inflationary pressures from the system—and they clearly feel that way—then an early taper driven by a desire to ensure smooth market functioning would argue for a later start to rate cuts.

While we are on board with considerable easing by the Fed this year (we forecast 150 bp worth of rate cuts), we see low odds of a March cut. But the odds that tapering begins by then is high. We believe tapering via higher reinvestment rates would be focused on the US Treasury market, either outrightly or as a greater percentage of total reinvestments per month. This would align with the Fed’s goal of having the balance sheet exclusively comprised of Treasuries.

Running off mortgage-backed securities (MBS) and reinvesting in Treasuries actively lower the MBS’ share of balance sheet even if the overall balance sheet is no longer shrinking at the same rate. The current environment makes it easier to focus 100% of reinvestment in Treasuries because the MBS market is much less negatively convex than in the past.

Lower-coupon longer-duration securities (2%-3% coupons) have very low prepayment risk due to the current level of mortgage rates, which increases their value in a rally and lowers the need for Fed support (unless defaults pick-up significantly). The case for slowing QT by focusing reinvestments solely on the Treasury market is strong.

Investment Implications

An increase in reinvestments in the Treasury market could potentially, all else being equal, reduce funding needs. A reduction in supply expectations could increase demand for longer-duration Treasuries, reducing term premia and limiting the extent of curve steepening (bull steepening) relative to past easing cycles.

We expect reinvestments focused on the Treasury market to not have material negative impact on the MBS market due to the reduced convexity risk relative to past cycles. If tapering were to involve a marginal increase in MBS reinvestments, Fed support for the sector would be a positive for overall MBS spreads because Fed reinvestments are likely to include a range of mortgage coupons.

In summary, a tapering focused solely on the Treasury market should be a positive for intermediate/long-term Treasuries and neutral for the MBS sector. Should some of the reinvestment be allocated to the MBS market, it would be marginally positive for overall MBS spreads.