Quantitative tightening is coming, but policy will remain accommodative

BofA Global Research with the note:

The December FOMC meeting minutes included a lengthy discussion of the timing and speed of Fed balance sheet shrinkage (quantitative tightening or “QT”). The broad message appears to be that QT will start sooner than it did in the previous tightening cycle, and proceed at a faster pace. Even so, we argue here that the Fed’s balance sheet policy will remain accommodative for the next several quarters:

  • The Fed has more than doubled its balance sheet during the pandemic.
  • Therefore it will have to reinvest a larger quantity of maturing Treasuries even while it is shrinking its balance sheet.
  • We expect QT to start in 4Q 2022. But we think the stance of Fed balance sheet policy will remain more accommodative than it was before the pandemic through end-2023.

The Fed doubled the pace of QE tapering at its December meeting. QE is now set to end in early March. Our rates strategists expect the Fed to start QT in October 2022, although the risks are for an earlier start, potentially after the June FOMC meeting. Until QT starts, the Fed will keep its balance sheet flat at around $8.7tn by reinvesting in Treasuries and mortgage-backed securities (MBS) as they mature.

Our rates strategists think the Fed will allow $10bn of maturing coupon-paying Treasuries to run off its balance sheet in the first month of QT (base case: October 2022). This “redemption cap” should rise to $40bn by January 2023 and then remain at that level. They also assume a $30bn redemption cap for Agency MBS. In total, this would allow the Fed’s balance sheet to shrink by $1.2tn through end-2024. They think the balance sheet could be cut further in future years, all the way down to $4.7tn, i.e. about 15% larger than its pre-pandemic level.

There is considerable debate about the exact mechanism through which balance sheet policy affects markets. Some investors think it is the size of the Fed’s balance sheet that matters. In that case Fed balance sheet policy is clearly easier than it was pre-Covid. Others think the change in the balance sheet, i.e., the size of asset purchases net of maturities, is the key variable. Then balance sheet shrinkage – QT – would certainly imply a tighter policy stance than the flat balance sheet policy of early 2020.

A third view is that gross asset purchases are what matter. We sympathize with this view. Why? The Fed replaces maturing assets via “add-ons” in Treasury auctions. For example, if the Fed plans to re-invest $10bn in an auction, the Treasury would reduce the size of its auction by this amount and then allocate $10bn worth of securities to the Fed at the market-clearing price. Markets price in this mechanism: the larger the add-on, the less is the supply that markets have to absorb, and the higher would be the marketclearing price. We think this amounts to an easier balance sheet policy stance.

Since the Fed’s balance sheet has more than doubled during the pandemic, keeping it steady would require significantly more reinvestment than would have been the case before the pandemic. Specifically, to keep its balance sheet steady the Fed would have to purchase (i.e., reinvest) nearly $400bn worth of coupon-paying Treasuries in 2Q and 3Q 2022, of which 59% were bought during the pandemic. This could buffer the impact of rate hikes. Recall that we are forecasting four hikes this year, one per quarter, as the Fed responds to sticky high inflation.

What about QT? Exhibit 1 compares our QT forecast to the maturity schedule of coupon paying Treasuries on the Fed’s balance sheet. The light blue bars represent Treasuries that were purchased in pandemic-era QE and the dark blue bars show those that were on the balance sheet pre-Covid. Quantities below the QT redemption cap (the yellow line) would run off the balance sheet while those above the cap would be reinvested.

Notice that in all but three months through end-2023, the redemption cap is less than the amount of maturing coupon-paying Treasuries that were purchased during the pandemic. Therefore in 2022 and 2023, reinvestments will generally exceed the amount of maturing assets that the Fed owned before Covid. In other words, the likely path of reinvestment under QT would have amounted to QE relative to the pre-pandemic Fed balance sheet. The bottom line is despite impending QT, the stance of the Fed’s balance sheet policy for the next couple of years should be more accommodative that it was pre-pandemic

Unconventional Economist
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