After getting so used to QE, and and rather liking it, now we’re facing the altogether harder world of QT
Some markets, including China, have already started drawing different conclusion as to the practical implications of the policy path the Fed’s embarking on
The Federal Reserve has raised rates and outlined its plans to shrink the size of its balance sheet but US Treasury yields haven’t yet taken the hint.
“Financial markets have utterly ignored this week’s communication from the Fed – at least in terms of the tightening profile,” wrote the Dutch financial services group ING on Friday.
Or perhaps the response of financial markets is a rational if counter-intuitive reaction to the Fed’s announcements. While the response so far doesn’t correspond to what might be considered the conventional narrative that naturally follows from the US central bank’s declarations, that doesn’t mean it’s wrong.
And if it’s not wrong, the implications are global.
But first the conventional view. As Nordea Markets set out in May, the combination of Fed rate hikes and balance sheet reduction should imply tighter financial conditions and a steepening of the yield curve as demand for US Treasuries is reduced.
Reduced Federal Reserve demand for US paper would drive sellers to accept lower prices. And as prices fall, yields rise.
But the Scandinavian bank also considered the out-of-consensus view that balance sheet reduction by the Fed could actually result in higher prices and lower yields for US Treasuries and a flattening of the yield curve.
Balance sheet reduction, in effect quantitative tightening (QT), might elicit a market response opposite to that seen under successive bouts of quantitative easing (QE) by the Fed.
Under QE, a reflationary process, as investors exchanged government bonds for central bank cash, that money found its way into other assets such as US corporate bonds, US equities and into emerging markets that offered better returns than US Treasuries. Of course, the selling of US dollars to fund purchases of emerging markets’ assets also drove the greenback down on the foreign exchanges.
It might be perfectly logical to see QT as having a disinflationary or indeed a deflationary impulse.
Under QT, it might be that the prices of US corporate bonds and US equities fall, capital comes out of emerging markets into the United States, and the dollar rises on the foreign exchanges. US dollars that are freed up might then flow back into US Treasuries, keeping prices buoyed and stopping yields rising.
Observed from this viewpoint, Beijing’s moves in recent months to buy US Treasuries makes sense. Equally, Beijing’s recent and much-discussed guiding of the yuan higher versus the US dollar would also make sense if there were an expectation that Federal Reserve balance sheet reduction would reinvigorate the greenback’s prospects.
A weakening of the yuan from a position of some strength is arguably less disruptive than a move down from an already-lower level.
When looking at how the markets may move, it’s also critical to bear in mind that markets anticipate and may already be looking ahead to the disinflationary implications that might accrue from higher benchmark US rates and accompanying Federal Reserve balance sheet reduction.
Of course none of this is to deny that balance sheet reduction is in itself a tightening of financial conditions. After all, if in 2010 the Fed equated the US$ 600 billion of its second round of QE to a 0.75 per cent cut in rates, then QT might be expected to have a similar but opposite impact, especially given its proposed scale.
As US firm BNYMellon pointed out last week, “based on these figures, the [Fed’s] balance sheet will run-off at a US$300 billion pace the first year, increasing to a US$600 billion/year pace by the end of year 2.”
Such tighter financial conditions might conventionally be expected to feed into higher US Treasury yields and a steepening yield curve, but that doesn’t take into account how QT actually works.
QT tightens financial conditions not by directly raising the price of money but indirectly by removing US dollars from the global monetary system.
Fewer US dollars kicking around makes the greenback a scarcer commodity, and given that it is the currency in which the world mainly borrows and in which much energy and many commodities are billed, that means the price for US dollars should rise as demand chases reduced supply.
In turn those who have US dollars may be minded to hang onto them. Such US dollars could well end up being parked in US Treasuries, pushing down yields and flattening the yield curve, even if the opposite outcome might have been expected.
Markets aren’t ignoring the Fed. Markets may just have drawn a different conclusion as to the practical implications of the policy path that the Fed is embarking upon.