FOMC's Quantitative Tightening: Best And Worst Case Scenarios
London (Oct 1) On Sept. 20, 2017, the Fed expressed its intention to start the QT (Quantitative tightening) process by allowing $10 billion of the bonds it holds to mature and not reinvest. The Fed currently holds $4,500 trillion on its balance sheet. $10 billion is a drop in that bucket. The Fed as promised is being extra careful with QT. Most likely, taking $10 billion liquidity out of the market every month will not be noticeable. The pace is said to be picked up eventually to $50 billion per month if the conditions are right. There is no clear indication on when the balance sheet will return to "normal", however some back-of-the-envelope calculations indicate 5 to 10 years. Recently, an article on Seeking Alpha (here) also showed 2025 as the year the balance sheet could return to its neutral value assuming everything goes according to plan. It is difficult to know how the monetary policy and with it the economy will move forward. Similar to when QE was announced and most experts expected high inflation to follow, QT can surprise as well. In this article, I will look at two extreme scenarios that can materialize. Looking at the extremes can help setting bounds on what to expect in the future and how to prepare for it.
Best-Case Scenario: What the Fed Dreams of Happening
In the best-case scenario, as the Fed reduces its balance sheet, the Treasury yields increase both long and short term. The increase in yields paves the path for interest rate hikes. This will take some liquidity out of the markets (stock market) as increasing Tbill yields will cause some investments to move from risk assets to Treasuries. In the ideal scenario, as the Fed removes some of the excess liquidity, the economy picks up steam and GDP grows at over 3%. The inflation under these conditions should pick up as well. In that case the corporate earnings grow materially (with GDP growth) and therefore a huge sell-off in the stock market is avoided. This supports a healthy yield for the Treasuries, higher interest rates (2.75% to 3.5%) and a healthy stock market. The stability never stays long in the market. It eventually overheats (inflation) and monetary policy (increasing rates) will lead to another recession (ideally mild). At that juncture, the Fed can cut rates and inject cash again into the markets to ease the pain of the recession.
SeekingAlpha
