The Federal Reserve will begin shedding billions in bonds off its balance sheet as part of the long anticipated quantitative tightening (QT) process. The move has broad implications across both equity and fixed-income markets. Therefore, it has rightfully caught the attention of retail investors across all segments.
The Fed will cease replacing its matured bonds, with the goal of dropping nearly $50 billion from its balance sheet in each of the next three months. After that, the central bank will actually ramp up its tightening, rolling off $95 billion per month until it deems it appropriate to stop. This is all in an effort to reduce its $8.9 trillion bond portfolio, the highest in the Fed’s history.
In 2017-2019, the most recent period of QT, the process indirectly caused a stock market selloff by putting upward pressure on interest rates and Treasury yields. This time around, QT will be even more aggressive, compounded by global central bank tightenings.
The QT process is arguably the single most hawkish action the Fed has taken thus far in its quest to lower inflation. However, interest rate hikes are a close competitor. But unlike the interest rate hikes, which analysts believe have already been priced into the market, QT may have surprising effects on financial interests.
Quantitative Tightening Presents a Slew of Impacts on Financial Markets
QT will likely cause a number of effects across financial fields. For retail investors, QT is likely to produce an eventual headwind for stocks. This is because the tightening process will increase the supply of bonds available to the public, lowering bond prices and raising yields. In times of uncertainty, investors already tend to gravitate toward safer, fixed-income investing options. Rising bond yields will only make stocks even more unattractive by comparison.
Reversing the Fed’s quantitative easing (QE) program is no small task. When Covid-19 first made waves across the world in early 2020, the Fed responded aggressively. As businesses shut down amid mass slowdowns in sales, the Fed worked tirelessly to keep the economy afloat. It did so largely by buying bonds, injecting money and liquidity into the economy.
Over the next three months the Fed will allow nearly $150 billion in bonds to fall off its balance sheet. By the end of next year the Fed is on track to drop $1.5 trillion from its balance sheet. It’s as far a step from QE as is possible, and the long-term effects the move may yield on the economy are uncertain.
No one can assert with absolute certainty what the impacts of QT may be, or when they may manifest. A balance sheet reduction of this scale is practically unheard of in the U.S. Rest assured, investors and analysts will be closely watching the markets as they respond to the latest central bank maneuver.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
