By Wong Kon How
The Fed balance sheet shrinks by $1tn and aims to cut another $1.5tn from its balance sheet by mid-2025.
During the initial phases of the Covid-19 pandemic, the central bank of the United States engaged in the purchase of trillions of dollars worth of government bonds and mortgage-backed securities. The aim was to provide stability to the financial system. However, since after the second half of 2022, the central bank adopted a strategy of allowing its holdings to naturally mature without initiating replacements.
“Quantitative tightening” or “Fed shrinking the balance sheet” refers to the same thing. It is a process where the Fed takes steps to reduce the amount of assets it holds on its balance sheet, effectively decreasing the money supply in the economy.
One of the key effects of quantitative tightening is that it puts upward pressure on interest rates. When the central bank sells assets or lets them mature without reinvesting, it absorbs money from the financial system, reducing the amount of reserves available for lending between banks. This can lead to higher short-term interest rates as banks compete for the remaining available reserves.
QT can potentially slow down economic growth. As interest rates rise, borrowing becomes more expensive for businesses and consumers. This can lead to reduced spending and investment, which can in turn affect economic activity.
Quantitative tightening can impact asset prices, including stocks and bonds. As interest rates rise, the yields on bonds become more attractive compared to stocks, which could lead to a shift in investment preferences from stocks to bonds. This might put downward pressure on stock prices. Additionally, the reduction in central bank asset purchases can remove a source of demand for certain assets, potentially leading to price declines.
Global Spillover Effects:
Quantitative tightening by a major central bank like the Fed can have spillover effects on global financial markets and economies. Capital flows might shift as investors seek higher yields in other regions, and emerging markets could face challenges due to reduced capital inflows and potential currency depreciation.
Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices tend to fall, and vice versa.
A complex situation for the US dollar:
Since major bonds are priced in US dollars, an increase in interest rates may not help with falling bond prices.
Expect more volatility ahead. The process of quantitative tightening can introduce uncertainty and potentially lead to increased market volatility. As the central bank adjusts its balance sheet and interest rate policies, market participants might reevaluate their positions and strategies, leading to larger price swings in various asset classes.