What You Need to Know About the Fed’s Quantitative Tightening

What You Need to Know About the Fed’s Quantitative Tightening

Posted On June 3, 2022 1:17 pm

On Wednesday, the Fed began draining the $3.3 trillion-plus bank reserves from its almost $9 trillion balance sheet, putting all of this money in motion; a process called quantitative tightening (QT). 

[Special Offer] Claim your $19 Trial into the trading service that’s delivered 39% to 122% annual profits to its members every, single year — The Options360!

Over the past few weeks, I’ve expressed concerns regarding QT as I think it could have more of a negative effect on the market than rising interest rates. 

Here’s what you need to know about the process and the number of ways it could create market turbulence.

Where did all this money come from?

Primarily from the unprecedented stimulus that the Fed unleashed when the Covid-19 pandemic crashed the global economy in early 2020. Over the last two years, it bought roughly $4.6 trillion of Treasuries and mortgage-backed securities through quantitative easing (QE) to keep longer-term interest rates low and stimulate the economy. Yet it created a wall of money that needed to get deposited somewhere, ballooning bank reserves. As the Fed embarks on policy tightening, the hope is that lenders pass that liquidity along as credit to companies and households, spurring growth.

How did so much money got parked with the Fed?

The growth in cash coincided with a pool of assets shrinkage where money-market funds can invest. The Treasury has been slashing its supply of bills since the end of 2020. While the Fed’s QE continued adding cash to the financial system, Washington’s late-2021 debt-ceiling drama, and now unexpectedly robust tax receipts, have left market participants in fierce competition for assets. Enter the Fed’s facility for overnight reverse repurchase agreements, where money funds can park up to $160 billion apiece and earn 0.80% — more than about 0.70% for a one-month Treasury bill.

Grab your $19 spot in the concierge trading service that earned its members 82% in profits for 2021 — The Options360!

How does Quantitative Tightening Work?

QT will reduce the supply of reserves as the Fed plans to roll over some of the bonds on its balance sheet at maturity without replacing it with other assets. If the amount of coupon-bearing debt maturing is less, it can fill the gap by not replacing some of its bills too. The government will then “pay” back the maturing bond by subtracting the sum from the cash balance that the Treasury keeps on deposit with the Fed; effectively making the money disappear. 

How will it affect liquidity?

There’s a growing consensus among Wall Street strategists that cash will drain faster from bank deposits than the Fed’s reverse repo facility (RRP). The expectation is related to the stronger-than-expected tax receipts that boosted cash in the Treasury’s account at the central bank — which operates like a checking account to nearly $1 trillion. After the government collected more than expected in income taxes in April, outstanding bank reserve balances dropped by a record $466 billion in the week that ended on April 20.  This was consistent with analyst expectations for how QT will evolve. 

What happens if excess cash leaves the banks faster?

If strategist expectations play out, one impact would be a rise in several short-term rates, from the effective fed funds rate to repo, as banks are forced to return to the market to borrow cash. It could also draw money funds away from the RRP and back to the private market. A third scenario could be banks becoming reluctant to add Treasuries or government agency mortgage-backed securities to their portfolios, just as the Treasury will need buyers for the securities it needs to sell. The risk of banks being short on funds sooner than expected would lift rates faster and push the Fed to incentivize institutions to hold reserves.

Is it time to worry about liquidity?

With bank reserves at about $3.3 trillion, we’re a long way from scarcity. Analysts think that point will come near the end of 2024 when reserves are expected to be somewhere around $2.5 trillion. Others estimate that a comfortable level of cash for banks is somewhere around $2 trillion. Investors will watch for any similarities to 2019 when a drop in reserves below the system’s comfort level helped fuel a disruptive spike in repo rates, a keystone of short-term funding markets.

Can the Fed prevent the repo market from imploding again?

The Fed has since created a permanent Standing Repo Facility (SRF), where eligible banks can exchange securities for dollars. Policymakers have said the tool could facilitate a faster balance sheet runoff, with some even suggesting it could reduce the reserves demand in the long run. Still, it’s not clear whether the SRF will serve as a sign of reserve scarcity, a tool to intermediate in the Treasury market when conditions become precarious, or a ceiling to help control the Fed’s key benchmark interest rate. 

All told, just as recent monetary actions including QE were unprecedented, QT will also be unprecedented and an extremely complicated undertaking. Both have some clear potholes that need to be avoided. There will likely be some unforeseen and unintended consequences; none are likely to be good for the market. 

[Final Offer] Claim your $19 offer into the trading service that has given its members profits every, single year since it started — The Options360!

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.