Understanding the Shift from QE to QT
In earlier articles I covered the terms bond tapering and quantitative easing (QE for short). In this article I want to talk a little about’ what is quantitative tightening’ or QT. QT has garnered a lot of interest from market participants since the U.S. The Federal Reserve Bank (Fed) hinted, at its last meeting in December, that an adjustable interest rate environment is 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?
What is Quantitative Tightening and How Does it Work?
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 arise. Alternatively, the Fed’s selling of bonds it acquired during QE is a faster and more impactful approach to balance sheet reduction.
What is quantitative tightening in this context? It can 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 Monetary Policy Sequence and Market Impact
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. Understanding the relationship between bond yield vs interest rate is key during these cycles, as yield reflects market pricing while interest rates are driven by central bank policy decisions.
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. This highlights what is quantitative tightening as a supporting mechanism within the broader monetary policy toolkit used to maintain economic stability.
Investment Strategies in a QT Environment
Markets are expected to be volatile this year due to aggressive Fed policies. And while there could be losses for investors who need to liquidate financial assets (stocks, bonds, etc), volatile markets also offer relatively attractive entry points for those investing 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. Understanding what is quantitative tightening and its market timing helps investors navigate these shifts.
Historically, sectors such as utilities, information technology and real estate get hurt by rising rates, while the financial sector usually benefits from rising rates and a steeper yield curve. Rising interest rates and shifts in the yield curve also affect fixed income markets, making the difference between premium vs discount bonds more relevant as yields adjust and bond prices respond accordingly.
Local Insights from Sterling Asset Management
For readers seeking a deeper dive into how QT influences portfolio decisions, we recommend our follow-up article: Why Quantitative Tightening Could Redefine Your Investment Strategy. It explores actionable strategies and the practical impact of QT on investor confidence, liquidity, and fixed income allocations.
For investors based in or looking toward the Caribbean, Sterling Asset Management continues to provide reliable guidance. As one of the leading investment companies in Jamaica, Sterling offers a range of fixed income solutions. Knowing when interest rates rise bond prices tend to fall is critical for those seeking to maximise returns while managing risk.
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 to learn more.
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If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm