The Implications of Quantitative Tightening

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The secret’s out. The Fed wants to shrink the size of its balance sheet, and they want to begin the process sometime this year. What does this mean for investors? And what does it mean for key variables such as interest rates, inflation, and economic growth? Let’s find out.

For those who may not recall, in the midst of the financial crisis, the Fed embarked on a bond-buying spree known as quantitative easing. This process involved the purchase of trillions of dollars’ worth of long-term Treasuries and mortgage-backed securities in an attempt to 1) suppress long-term rates, 2) inject liquidity into the financial system and 3) remove toxic assets from the balance sheets of public and private institutions.

Quantitative easing was phased out in 2014 but has left the Federal Reserve holding a massive $4.5 trillion balance sheet. This portfolio of bonds has remained steady in recent years as the Fed continues to roll over maturing Treasuries and reinvest the principal payments from the mortgage-backed securities.

In a recent commentary, the Fed has made it clear that it now wishes to begin the “unwinding” of its balance sheet, effectively relinquishing most of these assets back into the marketplace. This process has been dubbed “quantitative tightening,” and will represent another foray by the Federal Reserve into uncharted monetary waters.

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Over the last few years, the Fed has communicated to investors that it would not begin to unwind its balance sheet until normal monetary tightening (raising short-term interest rates) was well under way. Fed Chairwoman Janet Yellen recently said, “Before we turn that process on and start it, we want to make sure we have the adequate ability through our normal interest rate moves to meet the needs of the economy.”

Well … with three interest rate hikes under their belt, that time has now come, and so we need to prepare ourselves for another monetary event that none of us have ever experienced.

The minutes from the Federal Reserve’s May 2-3 meeting, which were released last week, give us the most up-to-date view of the FOMC’s current thinking regarding this process. So how will it all unfold?

Right now, the Fed’s plan doesn’t really involve “selling” any assets at all. Instead, the plan is to use a system of gradually escalating caps to allow assets to roll off the Fed’s balance sheet as they mature. According to the FOMC, “The caps would initially be set at low levels and then be raised every month, over a set period of time.”

The minutes do not specify what levels these caps might be set at, but many analysts are estimating the process, to begin with, a balance sheet drawdown of around $10 billion per month, possibly escalating to somewhere around $40 billion per month if and as conditions warrant.

As for timing, while the Fed has not made a definitive decision on this, they indicated recently that “ … as long as the economy and the path of the federal funds rate evolved as currently expected, it likely would be appropriate to begin reducing the Federal Reserve’s securities holdings this year.”

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The first step would entail a rewriting of the central bank’s official strategy for policy normalization, which is voted on by the committee. This could be published as soon as the Fed’s June 13-14 meeting, according to analysts at Morgan Stanley.

Okay, so the Fed’s plan is to begin allowing maturing assets on their balance sheet to roll off at a slow but steadily increasing rate, beginning later this year. What does this mean for investors and the broader economy at large?

The first thing I want to point out is that this process is likely to be very slow and uneventful. The Fed does not want to disrupt the economy and will use a data-dependent approach here, just as they do with rate hikes. Philadelphia Fed President Patrick Harker went so far as to refer to shrinking the balance sheet as “the policy equivalent of watching paint dry.”

While the unwinding of the balance sheet will be heavily telegraphed, the pace at which it occurs will be monitored and adjusted based on economic developments. The obvious goal is to avoid some type of “taper tantrum” such as the market experienced back in 2013 when the Fed attempted to wind down asset purchases. This triggered a sharp increase in Treasury yields, a collapse in equity markets and capital outflows from many emerging markets.

Nevertheless, quantitative tightening is still a form of monetary tightening, and will act to slow our economy and suppress inflationary forces. Do we need to be concerned when the Fed, which has a history of swinging the pendulum too far, frequently throwing the economy into recession, begins to “double tighten?”

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The answer here is yes and no.

We always need to be wary about monetary tightening because it has a strong history of ending economic expansions. But in this new era of central banking, the Fed has so far proven capable of taking a “steady as she goes” approach, rather than embarking on a preset “cycle” of policy changes.

Said differently, in the current environment the Fed is just as worried about downside risks as they are upside risks, and as a result, they are making their go/no-go decisions as the data evolves. I’ll give you an example.

In the previous rate tightening cycle (which ultimately led to the financial crisis) the Fed raised rates on what appeared to be a pre-programmed approach. They sequentially hiked interest rates four times a year for over four years straight, until financial conditions were so tight that we ultimately fell into the great recession.

This time around, after the Fed’s first interest rate hike in over a decade, it took the FOMC an entire year to implement the second. Three months later (March of this year) we saw the third, and then recently the Fed paused to allow the economy to acclimate to the new environment and observe the effects of their changes.

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As long as Yellen is in charge, I continue to see the Fed taking this slow and measured approach, and I believe the same philosophy will be taken with regard to unwinding the balance sheet: We’ll try a little and see how it tastes, then, if all is well, we can have a little more …

The other big consideration here is exactly how much balance sheet reduction needs to occur. Ben Bernanke recently wrote an article in which he discussed this. According to Bernanke, the growth in currency in circulation, which is a non-controversial driver of the size of the Fed’s balance sheet, has grown to around $1.5 trillion. Fed staff estimate that currency in circulation could grow to $2.5 trillion over the next decade, indicating an even lesser need for balance sheet reduction.

Whatever the final balance sheet size is, the growth our economy has experienced since the financial crisis dictates that the Fed’s balance sheet must be substantially larger than pre-crisis levels.

One particular Fed paper addressed this, projecting what the Fed’s balance sheet might look like over the next decade. You can see this is on the right side of the chart below.

http://dowtheoryletters.com/librepository/2017/May%202017/05-30-2017/M1.png

Notice in this projection that the trough in assets that occurs after the balance sheet has been unwound still sits north of $2 trillion.

As with many things in life, including rate hikes, the pace at which balance sheet reduction occurs is likely to determine the scope of the negative consequences. Done all at once, it would cause a massive dislocation to markets, but done slowly, it’s possible the whole process may go relatively unnoticed.

This is what the Fed is hoping for.

I highly doubt the accuracy of these estimates considering the multitude of variables involved, but Morgan Stanley and others have estimated that if $300 billion of securities roll off, it would be the equivalent of boosting short-term interest rates by 35 basis points (just over a quarter point).

Taking this analogy a step further, if we were to assume an average annual roll off of $300 billion (which would represent $25 billion per month – well inside the range currently anticipated) then this would amount to about one and a half quarter point rate hikes per year … a very modest tightening and one that is unlikely to have a major disruptive effect on financial markets.

Another interesting consideration here is that unwinding the balance sheet should have a larger effect on longer-term interest rates than short-term rates. This means that instead of pushing the short end of the yield curve higher (which would result in an overall flattening of the yield curve – a bad thing), quantitative tightening should push the middle of the curve higher.

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In theory, this will help foster a steeper yield curve than if the same amount of tightening were applied via the federal funds rate (a good thing), but again, these are uncharted waters so we will have to wait and see if this is really what happens.

Ultimately, the demand for yield, and especially low-risk yield is still so high that I can’t imagine global markets having a difficult time absorbing this new supply of Treasuries and mortgage-backed securities as they slowly come back into the market. But, I’ve been wrong before and could be here as well.

As you know, the ultimate direction of the long end of the yield curve is controlled by inflation expectations. And there’s a unique offsetting mechanism at play here. When the Fed allows assets from its balance sheet to mature, this effective supply is returning to the market. More supply, all else being equal, would lead to lower bond prices and thus higher interest rates.

But … and this is critical, the same factor that leads to a larger supply of Treasuries and mortgage-backed securities on the market also leads to reduced inflation expectations. After all, monetary tightening in any form is designed to slow the economy, and therefore inflation. And when inflation expectations deteriorate, it causes rates at the long end of the yield curve to move lower. (This is the exact same mechanism I’ve outlined before in describing how rate hikes at the short end of the yield curve often lead to longer term rates heading lower, not higher.)

So at the end of the day, it’s really anyone’s guess as to how this will all play out. Will a greater supply of Treasuries and MBS cause longer-term rates to rise? Or will quantitative tightening lead to a reduction in inflation expectations that causes longer-term rates to fall?

My best guess is that the two will largely cancel one another out, leaving us with a rate environment that looks very similar to what we have today.

I will say, as a final thought, that it is really the outlook on inflation that will determine everything. If inflation begins to slip, as it has in recent months (including the latest PCE data released today), then it’s conceivable that the Fed could push the pause button on BOTH quantitative tightening and rate hikes. With the employment component of their dual mandate largely met, the Fed has one main objective, and that’s to hit 2% inflation … everything now revolves around that.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.

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