Our view has been that the overall direct impact of the Federal Reserve's quantitative tightening (QT) program would likely be limited, and investors should not view it as a structural drag on asset returns. The Fed’s surprise dovish shift at the March FOMC meeting reinforces this view.
In our recent report, “What impact will QT have on financial markets?” we outlined several reasons why the Fed reducing the size of its balance sheet was unlikely to significantly affect markets, including:
- QT will likely be much smaller than QE. The Fed’s balance sheet will not fall back to pre-crisis levels. The balance sheet expanded fivefold from USD 900bn pre-crisis to a peak in 2017 of USD 4.5trn. We had expected the balance sheet to shrink to about USD 3.5trn. The Fed has now announced that the cap on the monthly run-off of Treasury securities will be halved to USD 15bn in May and will fall to zero in September. As a result, after September the Fed's total securities holdings should stabilize. This should leave the size of the Fed balance sheet at around USD 3.7trn.
- The Fed’s balance sheet will start growing again. Our view has been that to keep reserves (i.e. liquid deposits held by banks and financial institutions as a credit balance at the Fed that are not lent out or invested) at their desired level, the Fed would begin purchasing Treasury securities again once QT was finished. After September, the Fed has said it will allow excess reserves to very gradually decline over time to a level consistent with efficient and effective implementation of monetary policy. While there is considerable uncertainty over how long it will take, once reserves reach the appropriate level, the Fed will start increasing its securities holdings again. From that point onwards, the balance sheet should expand at around the same pace as nominal GDP growth.
The earlier end to the Fed’s asset run-off program, which will leave it with a larger-than-expected balance sheet, confirms our view that the impact of QT will be limited. The Fed has already signaled that there will be no more rate hikes this year.
Author: Vincent Heaney, Strategist, UBS AG
Brian Rose, Senior Economist Americas, UBS Financial Services Inc. (UBS FS)