Fed's New Year's Resolution May Include (Quantitative) Belt Tightening

In the Federal Reserve's just-released minutes from its December meeting, we learn just how it plans to handle the quantitative easing portfolio -- and how far it could go.

We already knew the Fed decided to accelerate the "tapering" of QE, such that it would no longer actively buy bonds by March. But from the minutes, we are now learning the Fed may take it a step further, perhaps starting quantitative tightening (QT) soon after the first rate hike. This would be a process of actively shrinking the Fed's balance sheet through roll-off or outright sales or both.

Let's see how this potential shift in strategy might impact interest rates.

Why consider shrinking the balance sheet?

Quantitative easing can impact the economy in a few different ways. A key way is that it raises the amount of reserves in the banking system, since the Fed uses newly created reserves to pay for the bonds it buys. If the banking system desires more reserves than it currently has, this can help ease that crunch. The other option for banks to get more reserves is to stop lending, which is obviously not what the Fed wants.

In the immediate onset of Covid, a reserve shortage was a major problem. But right now this is a non-issue. The Fed's Reverse Repo (RRP) facility keeps seeing record subscription, which is a sign that banks have more reserves than they need and are looking for a place to park them. This might be causing distortions in other parts of the money markets right now, but could make it harder for the Fed to actually push short-term rates higher when the time comes.

That banks so clearly have all the reserves they need tells the Fed that their balance sheet is currently bigger than it needs to be. Similarly, it means there is little risk of a sudden reserve shortage if the Fed began slowly selling bonds.

Could QT cause yields to spike?

One possible effect of QE is that it reduces the amount of bonds that need to find a buyer in the private market. In theory this should lower the yield of those bonds. If so, then the opposite move, where the Fed starts selling bonds, should have the opposite effect.

I'm a QE skeptic. Assuming there is adequate supply of reserves, the main impact that QE has is in signaling. It is a way for the Fed to tell the market they are "all in" on pumping stimulus, which can help convince the market that the Fed's interest rate target will hold at zero for a long time. Beyond that signaling effect, the direct impact of bond buying is relatively small. You can see this point in the chart below, which shows the 10-year Treasury yield during the QE/QT period from 2008-2019.

(Source = Bloomberg)

Take a look at the period in red, which was when the Fed was actively reducing its balance sheet in 2017-2019. We see that interest rates rise for most of 2017-2018, but then start falling at the end of 2018 into 2019 and wind up ending the QT period lower than it started. That may seem paradoxical, until you realize that pattern follows the market's forecast for future Fed rate hikes precisely. Up until the end of 2018, markets assumed the Fed would keep hiking at a similar pace as it had the previous couple years. At the end of 2018, there were signs the economy was slowing and markets started to assume rate hikes were about to stop. In actuality, not only did the Fed stop hiking, but cut three times in 2019, which led to the 10-year yield falling. In other words, it sure seems that rate target expectations were doing all the lifting, which leaves me skeptical that QT did a whole lot in and of itself.

That is not to say interest rates won't rise. But if they do it will be because the economy appears strong enough -- and inflation persistent enough -- to result in a longer rate hiking cycle. QT may play some role, but it will be minor compared to rate hike expectations.

Could the curve steepen?

Currently, the Fed's biggest footprint is in the longest part of the yield curve. The chart below shows the Fed's Treasury holdings in the System Open Markets Account (SOMA), which is where QE purchases are held.

(Source = Federal Reserve Bank of New York)

The blue bars are the percent of all outstanding bonds the Fed owns in a given maturity range. The orange bars represent what percentage of the Fed's holdings are in that bucket. E.g., the Fed owns nearly 50% of all Treasury bonds in the 10 to 20 year range, even though that's only about 10% of its total holdings.

So it would seem that the Fed's QT program could have an outsized effect on longer bonds. In other words, QT might cause the curve to steepen. I will certainly admit that if the Fed wanted to intentionally steepen the curve, they could, at least by some degree. They could just concentrate their QT sales in the long part of their portfolio.

But let's not overrate the prospect of such a thing, nor how large an impact it would have, anyway. I don't think manipulating the yield curve in this manner fits the Fed's typical MO. During the prior QE period, it did "Operation Twist," which was aimed at getting longer-term interest rates to fall, but that was in the name of supplying more stimulus at a time when their main target was stuck at the zero bound. To do a reverse Operation Twist today would be unlike anything the Fed has done in the modern era.

Moreover, I still don't think it would matter much. During the 2017-2019 period, the yield curve moved continuously flatter as long as the Fed was still in hiking mode and only steepened again once the Fed stopped tightening. Similar to the outright level of rates, QT didn't have any obvious independent effect.

Market reaction, trade ideas

The market took this as a very hawkish minutes release, primarily because of the QT talk. But the bond market is taking it as hawkish generally, as the yield curve is bear flattening. I still like positioning for this bear flattening to continue: Interest rates higher, but more so in the 5-year and shorter segment of the curve than the longer end.

At the time of publication, Graff was short 5-year, 10-year and Ultra 10-year Treasury futures.