Tightening threat overdone, but not over

Thought of the day

by Chief Investment Office 21 Feb 2019

The Federal Reserve's quantitative tightening (QT) program – which many investors worried was a threat to growth and markets – could come to an end this year, according to the minutes of the central bank's January meeting. The guidance is another sign that the Fed has become more sensitive to investor concerns. It was, after all, Fed Chair Jerome Powell's comment that QT was on "autopilot" that helped send equities plunging in December.

We don't think the Fed's QT program is likely to be a significant direct drag on the global economy and financial markets. For a start, the Fed's balance sheet reduction represents only a partial reversal of the post-2008 stimulus. We expect Fed assets, which expanded from USD 900bn pre-crisis to a peak of USD 4.5tr in 2017, to fall back only modestly to USD 3.5tr. Added to this, since investor demand for liquidity has fallen as investors feel safer, there is less danger that QT would cause liquidity to dry up or inflation to fall sharply.

But investors shouldn't yet fully discount the threat from quantitative tightening, from the Fed or other major central banks.

  • Balance sheet tightening still poses the risk of a communication blunder by the Fed. This was underlined by Powell's poorly-received "autopilot" comment in December. Badly managed communications can damage investor sentiment in the near term. While former Fed chair Janet Yellen said QT should be as interesting as watching paint dry, investors will be sensitive to shifts in QT policy.
  • QT from the European Central Bank (ECB) and the Bank of Japan (BoJ) could pose a greater threat, though this has not yet fully started. The BoJ is still in stimulus mode. And the ECB is only allowing its balance sheet to contract relative to its GDP. As both central banks move toward QT, however, risks will increase. Both the ECB and the BoJ were bolder in their use of QE, expanding their balance sheets to a greater degree than the Fed, relative to GDP, and purchasing a wider range of instruments. The situation could also be complicated by liquidity. The European corporate bond markets are not as liquid as the US Treasury market, raising the potential for a drying up of liquidity as the ECB unwinds.

So we think QT should remain on the radar for investors along with other risk factors, such as a breakdown in trade talks, a US credit crunch and a China hard landing. However, our base case is that the Fed can navigate this process. For more detail, see our recent report What impact will QT have on financial markets?

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