Fed Reaches $2 Trillion In Quantitative Tightening As It Cuts Rates

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Fed Reaches $2 Trillion In Quantitative Tightening As It Cuts Rates

seekingalpha2024-11-05

The Fed will cut the policy rate by 25 basis points at the November FOMC meeting while continuing with Quantitative Tightening, or QT.QT has reduced the Fed's SOMA portfolio by $2 trillion, but the ...

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Tast Nawarat Fed to Ease at November FOMC Meeting The Fed will hold their seventh, and next to last, FOMC meeting of the year this week, and at its conclusion on Thursday, November 7th they will cut their policy rate by 25 basis points. Federal Reserve and CME FedWatch This would be the Fed’s second consecutive rate cut, following their first easing in four- and one-half years at the September FOMC meeting. While the Fed surprised the markets with an aggressive 50 basis point cut in September, they will pare back their policy change this time to a 25 basis point reduction. Fed Funds Futures, as analyzed by CME FedWatch, imply a 98% probability the new Fed Funds Rate Range will be 4.5-4.75%. Quantitative Tightening Reaches $2 Trillion At the same time, the Fed just reached $2 Trillion in Quantitative Tightening ((QT.)) QT is the reduction in the Fed’s Balance Sheet through the run-off of Treasury securities and Mortgage-Backed Securities (MBS), as they mature, from the Fed’s System Open Market Account (SOMA.) After peaking at $8.8 trillion in April 2022, the Fed’s SOMA portfolio has dropped to $6.8 trillion, its lowest level since October 2020. Federal Reserve While $2 trillion in QT is significant, it only represents cutting 40% of the pandemic-induced Quantitative Easing (QE) increase in the SOMA portfolio. Additionally, the SOMA portfolio is only 23% lower than its all-time high, and is still 13 times larger than it was before QE began in 2008. Quantitative Tightening Drains Liquidity QT is a key element of the Fed’s Policy Normalization Plan that was announced in January 2022. The monetary policy tool the Fed is using to implement QT is to reduce their SOMA holdings through maturity runoffs, subject to a monthly cap. However, the Fed’s goal is to reduce the liquidity they injected during their periods of QE. Between 3Q2008 to 1Q2022 the Fed implemented several rounds of QE to battle two calamities, namely the Great Financial Crisis and the Pandemic. During these periods of economic hardship, the Fed injected tremendous amounts of liquidity by purchasing securities. Their Balance Sheet ballooned from $870 billion to $8.9 trillion. The liquidity the Fed injected also grew dramatically. The fear of QE was that the increased liquidity to the financial system would be inflationary. It, therefore, was always intended to be temporary. The Policy Normalization Plan, through the implementation of QT, was the way to reduce this excess. How We Got Here Under QE, to purchase their SOMA holdings, the Fed created Bank Reserves, which appear on the liability side of their Balance Sheet. In 2008, the Fed began paying Interest On Reserve Balances as a way to encourage banks to keep their reserves at the Fed. This feature became an important part of the Fed’s shift to their Ample Reserves Regime, and allowed the Fed to have more direct control over setting the Fed Funds Rate. This was a shift away from the Fed’s traditional Scarce Reserves Regime, where banks earned no interest on their reserves held on deposit at the Fed. Under Scarce Reserves, banks tried to limit their reserves to Required Reserves only. In 2013, the Fed instituted a second liquidity feature through Reverse Repurchase Agreements (RRPs.) They were a way for non-bank financial institutions to place short-term cash in a secured investment and earn a market rate of return. For the Fed, they provided another tool for conducting monetary policy. Together, Bank Reserves and RRPs, both of which are liabilities the Fed pays interest on, constitute the liquidity that was created during QE, and are the liquidity that the Fed wants to drain through QT. When Policy Normalization was announced in January 2022, Total Liquidity stood at $5.8 trillion. This was composed of $3.8 trillion in Bank Reserves and $2.0 trillion in RRPs. Federal Reserve Total liquidity actually peaked at $6.2 trillion in December 2021 as the Fed was preparing to implement their Policy Normalization Plan in response to a spike in inflation that they realized was not “Transitory.” Since QT began, Total Liquidity has fallen to $3.8 trillion. This represents the lowest level since March 2021. As can be seen in the above chart, most of the liquidity drain has come from RRP’s. After peaking at $2.7 trillion in March 2023, RRPs have plunged to the current level of $0.6 trillion. During that time, bank Reserves have remained relatively stable at $3.2 trillion. At a recent conference, Dallas Fed President Lorie Logan commented that “at present, liquidity appears to be more than ample. Reserve Balances are around $3.2 trillion, compared with around $1.7 trillion in early 2020. The economy and the financial system have grown…still, I think it is unlikely banks’ liquidity demand has doubled in half a decade.” This suggests there is more room to go with QT. QT Is The Equivalent Of 56 Basis Points In Rate Hikes Shortly after QT began in 2Q22, the Fed published a FEDS Note on the “Substitutability between Balance Sheet Reductions and Policy Rate Hikes”, which compared the impact of these two monetary policy tools. Their study estimated that in their baseline case, by 3Q24 QT would result in a $2.1 trillion reduction of the Fed’s Balance Sheet. They further estimated that QT would continue through 2Q25, for a total reduction of $2.5 trillion. Altogether, the Fed estimated that QT would be the equivalent of raising rates by 56 basis points. So far, the study’s baseline case is on target. Easing and Tightening Simultaneously It is notable that the Fed’s current QT policy is the equivalent of raising rates, while at the same time the Fed will be cutting rates. It suggests an internal monetary policy conflict. When questioned at the September FOMC meeting press conference about cutting rates while continuing with balance sheet runoff, Chair Powell said, “reserves are still abundant and expected to remain so for some time…we’re not thinking about stopping runoff because of this at all. We know that these two things can happen side by side…they’re both a form of normalization, and so, for a time, you can have the balance sheet shrinking but also be cutting rates.” To me, this is the equivalent of driving a car with one foot on the gas and one foot on the brake. It has never been attempted before at the Fed, and the net effect is still to be seen. How The Fed Benefits From Quantitative Tightening As I have written about often, the Fed has been losing money for over two years due to their Asset/Liability Mismatch. In short, the Fed is paying more for their variable rate liabilities than they are earning on their fixed rate assets. They are not happy with being in this position and want to get out of it. Their preferred exit strategy is through QT. As the Fed’s SOMA portfolio has declined, they have been able to reduce their weekly losses. At their peak, in late 1Q23 the Fed was losing -$2.8 billion per week. Through QT, as the Fed has pared their balance sheet and reduced their Asset/Liability Mismatch, their weekly loss position has improved. They are now losing -$1.4 billion per week, on average. Federal Reserve With the expected rate cut, their weekly earnings should continue to improve, although they will remain negative for the foreseeable future. Should The Fed Be Cutting Rates? The Fed has been under scrutiny to cut rates for quite some time. Starting in the summer of 2022, with only 4 rate hikes under their belt, and their policy rate at 2.50%, many market participants began looking for a Fed “pivot” to stop the rate hikes and start cutting rates again. Core PCE, the Fed’s preferred measure of inflation, had just dropped to 5.1% from the high of 5.6% when the Fed began tightening. Trading Economics It was shortly after that when Chair Powell began emphasizing his mantra that “rates will stay higher for longer.” His warning did not stop the market from looking for a pivot. Despite 7 additional rate hikes, and 14 more months of rates plateauing at the elevated 5.25 – 5.50% range, market participants were still clamoring for a pivot. Finally, in August 2024, at the Kansas City Fed’s Annual Symposium in Jackson Hole, a full two years later, Chair Powell uttered the famous words “The time has come for policy to adjust.” The data dependent Fed was then looking at a Core PCE of 2.7%, and an unemployment rate of 4.3%. Trading Economics Powell felt that “The upside risks to inflation have diminished. And the downside risks to employment have increased.” And so, at the September FOMC meeting, the Fed cut rates by 50 basis points. They also suggested more cuts were to come. But since then, the data haven’t moved materially. We’ve had two more Core PCE readings of 2.7%, still significantly above the Fed’s target level of 2.0%, and we’ve had two additional unemployment rates declining to 4.1%. October’s non-farm payroll report surprised to the upside, and while November’s release was a lower than expected with 12,000 new jobs, the number should be discounted because of the effects of two hurricanes and a Boeing strike. BLS indicated their data collection was affected by these events, but said it is not quantifiable. In sum, there was no meaningfully different new data to justify another cut. The bond market didn’t seem to like the cuts either. Over the past 35 years, there have been six periods where the Fed cut rates for the first time in an easing cycle. They are shown in the chart below, courtesy of Bianco Research LLC. Bianco Research LLC During three of the periods, 10-year Treasury Note yields (US10Y) rose over the next month following the first rate cut. The average yield increase for these three episodes is 22 basis points. During the other three periods, 10-year Treasury Note yields fell, for an average decline of 25 basis points. The yield decline for the 10-year Treasury Note averaged -2 basis points for all six periods. Yet with the Fed’s rate cut in September, 10-year Treasury yields rose by 74 basis points over the next month! Why are long rates rising? James Bianco, President at Bianco Research and one of the most astute market analysts around, opined:  “The simple answer is that the Fed is cutting rates, and the market thinks that is a mistake. Why? -The Economy is good -Inflation is not “solved” (and tariffs are inflationary) -Don’t need monetary stimulus We have never seen long rates rise this much after a rate cut.”  Conclusion The Fed will cut their policy rate by 25 basis points when the FOMC meeting ends on Thursday, November 7th. At the same time, they will continue with their QT program, which is part of their Policy Normalization Plan. QT is important to the Fed because it is the only way they can eliminate their Asset/Liability Mismatch. Since implementation, the Fed has reduced their SOMA portfolio by $2 trillion, which represents a 40% drop in the securities they purchased during the pandemic-induced QE program. Total SOMA holdings are 23% below their all-time high of $8.8 trillion, but still 13 times greater than before they began with QE. With their easing, by cutting their policy rate by 25 basis points, while at the same time tightening by continuing with their QT Policy Normalization, the Fed is implementing a conflicted monetary policy, which they have never done before. The bond market response hasn’t been favorable, as long Treasury rates have risen significantly while the Fed is cutting short rates. This has never happened before.  As Jim Bianco stated, “The bond market thinks that is a mistake.”","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"policyRegulatory,analysis","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"hasMoreComments":false,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false}}