Quantitative tightening – What is it?

In earlier articles I covered the terms bond tapering and quantitative easing (QE for short). In this article I want to talk little about quantitative tightening or QT. QT has garnered a lot of interest from market participants since the U.S. Federal Reserve Bank (Fed) hinted, at its last meeting in December, that interest rate adjustments are likely this year to counteract high and persistent inflation. So, what is QT, how is it related to tapering and or QE and what are the implications for markets and investors?

QT is the opposite of QE. In quantitative easing, monetary policy is loosened or eased as central banks inject liquidity in the financial system by purchasing financial assets such as bonds on the secondary market. For example, the Fed had been buying US$120 billion of bonds monthly since the start of the pandemic but has recently reduced the quantum of purchases (“tapering”) and will ultimately end QE in March 2022. QE 2020 - 2022 has caused a doubling of the Fed’s balance sheet to US$8.8 trillion and so at some point the Fed will need to return the size of its balance sheet to resemble normal levels. To do so, the Fed can simply allow the maturity of existing bonds to naturally reduce the size over time. However, this strategy could take a very long time and likely hinder the Fed’s ability and capacity to provide meaningful support to financial markets in the future should the need arises. Alternatively, the Fed’s selling of bonds it acquired during QE is a faster and more impactful approach to balance sheet reduction. QT can therefore be regarded as the selling of bonds previously acquired by central banks to shrink their balance sheet as well as tighten liquidity or the quantity of money supply in the financial system. QT is usually deployed after a rate hiking cycle.

The sequence of events usually flows as follows: QE - bond tapering - rate hikes - QT. Market attention has however shifted to the increasing probability of the Fed actioning QT this year in tandem with rate hikes. The Fed is likely to begin its rate hiking cycle in March and markets are pricing in an “aggressive Fed” with four rate hikes this year to counteract high inflation. One fear is that aggressive rate hikes could lead to a flattening and ultimately inversion of the yield curve (longer-term rates exceeding shorter term rates) which usually signals an impending recession. Deploying QT and rate hikes simultaneously is therefore intended to steepen the yield curve and delay any recession signs ahead. Executing QT earlier, may also result in a relatively shorter Fed rate hiking cycle compared to the last one which ran from December 2015 to December 2018. QT is however not expected to happen until much later in the year. 

Markets are expected to be volatile this year due to aggressive Fed policies. And while there could losses for investors who need to liquidate financial assets (stocks, bonds, etc), volatile markets also offer relatively attractive entry points for investors particularly those who invest for the medium to long term. A steeper yield curve should also present higher yielding longer dated bonds which are useful acquisitions for income seeking investors. Historically, sectors such as utilities, information technology and real estate get hurt by rising rates, while the financial sector usually benefit from rising rates and a steeper yield curve. 

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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