Don’t sleep on QT

Good morning. Nice rally yesterday. Enough to drag Microsoft, after faceplanting to start the day, back into the green by the end of it. We’ve now mostly erased May’s losses. Durable bounceback or bear market rally trickery? Send us your thoughts: robert.armstrong@ft.com and ethan.wu@ft.com.

QT will matter, a lot

How much will quantitative tightening matter to risk asset prices? Some shrug it off, arguing that the Federal Reserve’s bond market operations only matter in that they constrain the timing of interest rate moves. Others see QT as a weak-sauce substitute for rate increases. Fed governor Christopher Waller recently hazarded a guess that shrinking the central bank’s balance sheet would have an impact similar to “a couple of 25 basis point rate hikes”.

This estimate seems conservative, given that when QT reaches full speed in September, the Fed’s balance sheet will be shrinking at a rate of $1.1tn a year. That’s $1.1tn more government paper in private hands, and $1.1tn less liquidity — reserves and bank deposits — sloshing around the financial system.

Joseph Wang, on his “Fed Guy” blog, offers a strong argument for why QT will matter a lot. Here is a summary:

1. During QT, the Fed allows bonds it owns to mature without buying new ones. The Treasury pays the Fed the principal amount of each bond. The Fed then destroys the money it receives. The Treasury then needs to raise new money to replace what it paid. It sells new debt to the public, pulling liquidity (aka cash, aka bank reserves or deposits) out of the financial system, replacing it with Treasury paper.

2. There is another, parallel process: the Fed’s “reverse repo programme”, which exists to mop up liquidity that would otherwise drive short-term interest rates below the Fed’s target. Under the RRP, investors give cash to the Fed and receive Treasuries (and a yield) in return. The effect, again, is to pull liquidity out of the financial system and put Treasury paper into it.

3. If investors withdrew cash from the RRP in order to buy the new Treasury bonds, the liquidity impact would be a wash. But that is unlikely. The main investors in the RRP are money market funds. They could withdraw cash from the RRP and lend it to hedge funds, who would then use the borrowed money to buy Treasuries. But leveraged Treasury bets are not in fashion right now. Rate volatility (see below) makes them too risky. So the RRP is likely to grow, even as QT proceeds. Both processes will absorb liquidity.

4. Liquidity will therefore fall just as demand for it rises. Investors are seeking safety from ugly stock and bond markets. Investors who want cash will have to sell their stocks and bonds at lower prices to get the cash they so badly want, and “the market rout will continue”. 

There is an important proviso here, which Wang notes. There is another source of liquidity which could replace what is absorbed by QT and the RRP: bank lending. When banks make loans or buy an asset, they create money. And they have created a lot of it recently. Bank credit has risen by $1.5tn in the past year. Indeed, since the coronavirus pandemic began, bank credit has been growing at rates not seen since before the financial crisis:

The Fed is draining liquidity from the financial system with the RRP. QT will start draining more now. So far, banks have replaced it. Whether they will continue to do so is a huge question for investors.

Deceptive calm in the bond market

The year started with a nasty rout in Treasuries, as investors realised that high inflation was for real and the Fed would try to stop it. Yields rose across the curve, and kept on rising. But in the past month or so, things have changed. The bear market in bonds is on pause:

Now you can get a half-decent return on riskless Treasuries, and that has prompted inflows into bond funds:

What’s going on? One way to interpret the sideways movement is as reflecting a tension between contradictory indicators. On the one hand, for example, consumer demand remains strong, which would suggest sustained inflation and higher rates. On the other, there are early signs that growth is cooling — wage growth is moderating, for one. A softer job market would allow the Fed to back off sooner.

The futures market currently implies a peak fed funds rate of about 3 per cent. Mark Cabana at Bank of America thinks that number could change a lot as new data rolls in. He’s watching the labour market in particular:

When the labour market peaks — meaning when the unemployment rate or [jobless] claims trough — that tends to coincide in a matter of months with the peak of interest rates. But do we know if the labour market has peaked or not? We don’t.

By contrast, Columbia Threadneedle’s Ed Al-Hussainy, Unhedged’s rates expert at large, thinks we don’t need to wait and see. The data we already have shows that rates must head higher, and quickly, to curtail inflation. The jobs market, consumer demand, financial conditions and inflation itself all scream for tighter policy:

Gosh, we don’t have a green flag on any of those. Of those four factors, maybe slightly yellow on financial conditions because, yeah, things have tightened. Is it enough? No, probably not . . . It’s too early for ‘wait and see’.

If Al-Hussainy is right, rate volatility is going up. Current prices don’t reflect where the Fed is going or how fast it has to get there. But even if Cabana is right, that too could be a recipe for volatility. Markets are likely to react violently to new data drops, as new trends emerge slowly. The current sideways pattern seems unlikely to last. (Ethan Wu)

One good read

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