To The Moon

Entering September, the global market ushered in an important change: the Fed's quantitative tightening (QT) accelerated.

Although it has been more than three months since the Fed started quantitative tightening in June, under the aggressive interest rate hikes, QT, which has a very low sense of existence, has not caused much trouble, and in the case of sufficient bank reserves, the impact of shrinking the balance sheet is indeed limited.

However, with the progress of the reduction of the balance sheet and the doubling of the monthly scale, the market began to feel uneasy, and worries began to rise.

The Fed officially started to shrink its balance sheet in June, with a monthly cap of $47.5 billion from June to August, and this rate will double in September, raising the limit to $95 billion, including $60 billion in U.S. Treasuries and 35 billion in mortgage-backed securities (MBS), or about 1% of the balance sheet.

Balance Sheet Data from St. Louis Fed, chart by Mish

According to statistics, the Fed has absorbed $2.2 trillion in reserves from the banking system in the form of overnight deposits, compared with zero at the beginning of last year.

For now, the reduction in reserves is not a problem, and banks still have $3.3 trillion in reserves, more than at any time before last year, but there are risks.

Analysts pointed out that,

• on the one hand, with the acceleration of QT and the decline of bank reserves, the willingness of banks to take risks will decrease, which will affect the overall liquidity of the market.
• On the other hand, when reserves fall below safe levels, the Fed will have to stop rolling off its balance sheet early in order to avoid a damaging spike in repo rates.

This also means that the Fed will have to adopt more aggressive interest rate hikes to make up for the lack of rolling balance sheets, and the impact on the market will be self-evident.

Regarding the impact of QT, Yellen, the former chairman of the Federal Reserve and the current U.S. Treasury Secretary, once had a vivid metaphor: "It's like watching the paint dry, which is unremarkable."

Solomon Tadesse, head of quantitative strategy for equities in the Americas at Societe Generale, wrote in a note last week: From a policy perspective, a lack of awareness and clear communication of the potential impact of QT could create the risk of over-tightening. On the market side, an increase in QT could trigger the next drop in the market. In other words, investors haven't realized how aggressive the QT cycle is going to be.

Hedge fund giant Bridgewater is also concerned about the impact of QT. The company believes that the market will be plunged into a "liquidity hole" as a result. Bank of America equity strategist Savita Subramanian believes that QT alone could lead to a 7% drop in shares as the boost from quantitative easing reverses.

Alex Lennard, investment director at Ruffer LLP, a British investment manager, said an accelerated sell-off in the Fed's holdings of U.S. Treasuries would suck liquidity out of the market, just as rising interest rates and falling stock and bond prices would increase demand for cash. Shock to stock and bond markets."

Deutsche Bank strategist Tim Wessel noted in a recent report that the Fed may stop QT when bank reserves fall to $2.5 trillion. At the current rate at which money market funds are taking deposits and placing them in the Fed's reverse repo facility, that level could be reached as early as January 2023.

Details of QT Path:

Source: https://mishtalk.com/

Plans for Reducing the Size of the Federal Reserve's Balance Sheet

• In January 2022, the Fed announced an intention to start QT.
• In May, the Fed announced itsPlans for Reducing the Size of the Federal Reserve's Balance Sheet.
• In June the Fed finally got around to doing QT.
• From January until March, despite a housing market totally out of control, the Fed kept doing QE (both treasuries and mortgage backed securities (MBS)

Plan Caps

• Beginning on June 1, principal payments from securities held in the System Open Market Account (SOMA) will be reinvested to the extent that they exceed monthly caps.
• For Treasury securities, the cap will initially be set at $30 billion per month and after three months will increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon maturities are less than the monthly cap, Treasury bills.
• For agency debt and agency mortgage-backed securities, the cap will initially be set at $17.5 billion per month and after three months will increase to $35 billion per month.

June 1, 2022 Assets

• Total Assets: 8,915,050
• Treasuries: 5,770,779
• MBS: 2,707,446

August 24, 2022 Assets

• Total Assets: 8,851,436
• Treasuries: 5,700,628
• MBS: 2,725,906

Three-Month Apparent Progress

• Total Assets: 8,915,050 - 8,851,436 = 63,614
• Treasuries: 5,770,779 - 5,700,628 = 70,151
• MBS: 2,707,446 -2,725,906 = -18,460

Apparent Progress Notes

The key word regarding progress is the word "apparent".

On August 20, I commentedYes, Quantitative Tightening by the Fed is Really Happening

Here is an explanation from Joseph Wang, a former senior trader who handled QE trades for the Fed.

MBS Holdings Really Are Declining

The Fed’s MBS holdings are decreasing, even if this is obscured by the sawtooth pattern of its holdings, which arises from the repayment and settlement schedule of MBS, wherein MBS bonds receive principal repayments on the 25thof the month and newly purchased MBS settle on the 15thof the month. The spikes in Fed MBS holdings arise from the settlement of newly purchased MBS; the declines are due to principal repayments. The Fed is still receiving MBS principal repayments each month that must be reinvested, so its MBS holdings continue to show periodic spikes even as overall MBS holdings are declining.

The Fed’s policy of settling MBS purchases within a three-month window adds another wrinkle to understanding Fed MBS holdings. The Fed is the largest investor in the MBS market and aims to minimize any potential disruption by postponing MBS settlement if it judges that postponement would improve market functioning.This means some of the increases in the Fed’s MBS portfolio could arise from purchases conducted three months ago, including purchases from reinvesting principal received the period between the end of QE and the start of QT.These delayed settlements are recorded as commitments to buy MBS and have steadily declined over the months. These commitments obscure the steady drop of Fed MBS holdings but will dissipate in a few months.

Just Wait for September

QT is taking place exactly as the Fed has telegraphed and the balance sheet declines will become more apparent in the coming months. Soon the QT pace will quicken, and all past-purchased MBS will have settled. From that time, the Fed’s balance sheet will clearly and steadily decline each month.

Projected Principal Payments

New York Fed Projected Payments