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The Fed’s quantitative tightening is about to arrive: What it could mean for the markets

The Federal Reserve’s $9 trillion portfolio is about to be reduced starting Wednesday, in an operation aimed at completing rate hikes and supporting the central bank’s fight against inflation.

While the exact impact of “quantitative tightening” on financial markets is still being discussed, analysts at Wells Fargo Investment Institute and Capital Economics agree that it will likely produce further headwinds for stocks. This is a dilemma for investors who face multiple risks to their portfolios at the moment, as government bonds sold out and stocks took losses on Tuesday.

In short, “quantitative tightening” is the opposite of “quantitative easing”: it is essentially a way to reduce the money supply circulating in an economy, and some say it helps drive prices higher in a predictable way — though, by how much remains unclear. . And it could turn out to be something as non-boring as “watching the paint dry,” as Janet Yellen described it when she was Fed chair in 2017 — the last time the central bank started a similar process.

The main effect of QT is in the financial markets: it will likely increase real or inflation-adjusted returns, making stocks somewhat less attractive. And it should exert upward pressure on treasury term premiums, or the compensation investors need to take on interest rate risk over the life of the bond.

Moreover, the quantitative tightening comes at a time when investors are already in a very bad mood: optimism about the short-term trend of the stock market is below 20% for the fourth time in seven weeks, according to survey results. Released Thursday by the American Association of Retail Investors. Meanwhile, President Joe Biden met with Federal Reserve Chairman Jerome Powell on Tuesday afternoon to discuss inflation, a topic that is at the forefront of many investors’ minds.

Read: Biden pledges commitment to central bank independence while Fed Chair Powell meets Biden’s inflation meeting with Fed Chair Powell seen as ‘politically beneficial to the president’

“I don’t think we know the effects of QT yet, especially since we haven’t done that balance sheet reduction very often in history,” said Dan I, chief investment officer at Pittsburgh-based Fort Pitt Capital Group. “But it is a safe bet to say that it takes liquidity out of the market, and it is reasonable to believe that as it withdraws liquidity, it affects valuations to some extent.”

Starting Wednesday, the Fed will begin reducing its holdings of Treasury securities, agency debt and agency mortgage-backed securities by a total of $47.5 billion per month for the first three months. After that, the total amount to be cut rises to $95 billion per month, as policymakers prepare to adjust their approach as the economy and financial markets develop.

The reduction will occur when the outstanding securities roll out of the Fed’s portfolio and the proceeds are no longer invested. As of September, the offerings will occur at a “much faster and more robust” pace than the process that began in 2017, according to the Wells Fargo Investment Institute.

By the institute’s calculations, the Federal Reserve’s balance sheet could shrink by about $1.5 trillion by the end of 2023, bringing it down to about $7.5 trillion. And if QT continues as expected, “this $1.5 trillion balance sheet reduction could equate to another 75-100 basis points of tightening,” at a time when the federal funds rate is expected to be around 3.25% to 3.5%, the institute said in Note this month.

The target range for the fed funds rate is currently between 0.75% and 1%.

Sources: Federal Reserve, Bloomberg, Wells Fargo Investment Institute. Data as of April 29.

“Quantitative tightening may add upward pressure on real yields,” the institute said. “Alongside other forms of tightening in financial conditions, this presents another headwind for risk assets.”

“We expect the Federal Reserve to reduce its asset holdings by more than $3 trillion over the next two years, enough to bring the balance sheet back into line with the pre-pandemic level of GDP,” said Andrew Hunter, chief US economist at Capital Economics. Although it shouldn’t have a significant impact on the economy, the Fed may halt QT prematurely if economic conditions turn out to be “bad,” he said.

“The main impact will come indirectly through impacts on financial conditions, with QT exerting upward pressure on Treasury term premiums, which, combined with a further slowdown in economic growth, will add to the headwinds facing Stock market”. He said the main uncertainty is how long the Fed crisis will last.

On Tuesday, all three major US stock indexes ended lower, with the Dow Jones Industrial Average, the Dow Jones Industrial Average,
-0.67%
slip of 0.7%, S&P 500 SPX,
-0.63%
Down 0.6%, the Nasdaq Composite Index,
-0.41%
by 0.4%. Meanwhile, Treasury yields rose as bonds sold across the board.

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