A screen shows the Fed’s interest rate announcement as a trader (in a post) works on the floor of the New York Stock Exchange (NYSE) in New York June 15, 2022.
Brendan McDermid | Reuters
The US Federal Reserve struck a dovish tone on tackling inflation via monetary policy last week, but analysts are concerned about the potential threat from its continued tightening strategy.
Fed Chair Jerome Powell warned that the US economy will suffer “some pain” as the central bank continues to hike interest rates aggressively, prompting markets to sell off again amid the increased prospect of a recession.
Markets around the world sold off on apparent confirmation that monetary policy tightening is being front-loaded, likely compounding the risk of a recession as policymakers focus on the Fed’s interest rate as the primary anti-inflation tool.
But in a research note on Tuesday, analysts at London-based CrossBorder Capital argued that the “quantitative liquidity dimension” is being overlooked as the Fed’s balance sheet shrinking — or quantitative tightening — is having an asymmetric impact on the economy.
“The Fed sees QT/QE as an ‘air conditioner’ buzzing in the background, but we see QT as a wrecking ball that will eventually morph into yet another QE,” CEO Michael Howell said in the statement.
CrossBorder warned ahead of Powell’s Jackson Hole speech that the Fed’s actions are raising the risk of an “imminent major policy error,” particularly the “financial stability implications of excessive QT.”
Quantitative tightening
Quantitative tightening is a monetary policy tactic used by central banks to reduce liquidity and shrink their balance sheets, typically by selling or maturing government bonds and removing them from the bank’s treasury.
CrossBorder Capital believes that central banks are sucking too much liquidity out of financial markets too quickly, and Howell pointed to a recent radical shift by some European Central Bank policymakers, which he believes is leading to euro instability and eventual central bank liquidity swings in the European Central Bank could trigger in 2023.
“Our concern is that QE/QT has outsized implications for financial stability, with the proposed contraction in the Fed balance sheet by nearly a third equating to about 5 percentage points added to Fed funds,” Howell said.
“Sometime in 2023, the Fed will be forced to rebuild its balance sheet and lower the US dollar. Until that point is reached, there will be major QT (quantitative tightening) over the next several months. This should scare the markets.”
Concerns about QT were echoed by Mazars chief economist George Lagarias, who urged traders and investors to forget what they heard from Powell in Jackson Hole and instead focus on Fed assets as a single leading indicator.
The Fed raises its quantitative tightening ceiling to $95 billion from $45 billion. Meanwhile, the ECB ends its quantitative easing in September, albeit with a program to limit fragmentation between lending rates in highly indebted and less indebted member states.
“Will [the Fed’s cap increase] quickly siphon off money from the markets? His true intentions will be shown in this area, not in political speeches,” Lagarias said on Tuesday.
“In the meantime, investors should be concerned about the longer-term implications of the Fed’s stance. The slowdown could lead to a deep recession. Inflation could turn into deflation.”
He pointed out that emerging markets and US exporters are already suffering from the strong dollar, while consumers are “at the end of their tether”, especially in the current circumstances where central banks are gearing their policies towards wage restraint at a time of the cost of living crisis.
“The time when central bank independence will be questioned may not be that far off,” Lagarias mused.
Do you underestimate the impact of QT?
When the Fed trimmed its bond portfolio in 2018, it led to the infamous “taper tantrum” – a violent sell-off in markets that prompted the central bank to moderate policy and slow the pace of Treasury sales.
“Central banks argue that they can afford to reduce their bond holdings because commercial banks have ample reserves and the central bank doesn’t have to hold as much of the government bonds issued,” said Garry White, chief investment commentator at UK investment manager Charles Stanley , said in a note ahead of Powell’s Jackson Hole speech.
“More of this could be held by the private sector at the expense of their bank deposits. Central banks may be underestimating the impact of significant quantitative tightening.”
Governments will aim to sell significant amounts of debt over the coming years, with fiscal policy becoming unprecedentedly loose amid the Covid-19 pandemic in early 2020.
White indicated that the end of central bank asset purchases would mean governments would have to pay a higher interest rate to deleverage.
“If central banks became sellers of government bonds, the difficulties would be even greater,” he said.
“For now, the main objective of the Fed and ECB is to end all new bond purchases and allow portfolios to be wound down as governments must repay bond debt when it matures.”
Beat Wittmann, chairman and partner at Zurich-based Porta Advisors, also recently warned of the growing risk of a “major financial disaster” that could lead to a market capitulation later in the year.
“The list of vulnerability candidates is quite long and includes zombie-like European universal banks, LBO [leveraged buyout] financed companies, overleveraged shadow banks and overleveraged emerging market government bonds,” said Wittman.
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