The Fed will soon begin to reduce its balance sheet by $9 trillion. Here’s why investors are afraid of “quantitative tightening”.

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  • After years of quantitative easing by central banks, quantitative tightening is the new watchword.
  • The Fed and others are considering shrinking the size of their balance sheets, cutting support for markets.

Central banks have flooded struggling economies with trillions of dollars over the past decade and a half, in a now well-known policy called quantitative easing, or QE.

But the Federal Reserve – along with other central banks – is now preparing to put its engine into reverse and start shrinking its $9 trillion balance sheet as it grapples with the strongest inflation in 40 years.

The new watchword is “quantitative tightening”, or “QTIt’s never been done before on this scale, and it’s scaring investors.

What is quantitative tightening?

Simply put, QT is the process of reducing the size of the Federal Reserve’s balance sheet, i.e. its assets and liabilities.

Under QE, Fed assets soared to $8.9 trillion from less than $1 trillion before the 2008 crisis.

Its assets have doubled since the start of the pandemic as the Fed created money and bought obligations in an effort to contain yields and borrowing costs, encouraging people to borrow and spend.

Now, however, the Fed is poised to raise interest rates as it tackles inflation.

And to give it more firepower, the Fed also said it would likely stop reinvesting money from its maturing bonds, gradually reducing its support for the fixed-income market.

Instead, it will simply remove the money from existence with a few keystrokes, just like it conjured up in the first place. The Fed may even begin to actively sell the bonds it holds, although it is not yet taking this option seriously.

In theory, if QE lowers bond yields and raises inflation, then QT should do the opposite. Analysts estimate that the process will begin during the summer.

Why are investors worried?

Traders and investors have been bruised by past experience.

The Fed only tried QT once before, in 2018, and it didn’t go so well for the markets. Stocks fell sharply in 2018, with the S&P 500 falling more than 6%. After about 10 months, the central bank reversed the policy.

Still, Hugh Gimber, global strategist at JPMorgan Asset Management, said 2018 was a bad guide because there was so much else going on, including the US-China trade war.

Still, it’s “definitely an uncertain time for investors,” he told Insider.

QT on this scale has never been attempted before. From May 2022 to May 2023, the four largest central banks – the United States, the eurozone, the United Kingdom and Japan – are expected to shrink their balance sheets by $2 trillion, according to Morgan Stanley economists. This is four times more than in 2018.

Even the Fed isn’t sure what’s going to happen. He said in December that raising interest rate is the surest way to fight inflation, as there is “uncertainty” about “the effects of changes to the Federal Reserve’s balance sheet.”

What can happen to stocks?

For Gimber, the Fed’s plans to raise interest rates and initiate QT will add upward pressure on bond yields, which have already risen this year.

This should continue the so-called rotation from growth stocks, such as technology companies that have benefited from low interest rates, to more economically sensitive sectors such as energy and financials. Gimber, however, expects more volatility.

But Steven Major, head of fixed income research at HSBC, told clients in a recent note that yields could actually fall when QT begins because they have already jumped higher than they should have anticipated. .

Even so, he said, “during QE equities outperformed bonds, so maybe with QT the valuation challenge is more on equities.”

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