What is Quantitative Tightening, and How Does It Impact Riskier Assets?

By Thomas, content writer Tuesday, 17 January 2023


Thomas, content writer

The term quantitative tightening describes a process within monetary policy where a central bank is contracting liquidity by shrinking its balance sheet. To understand quantitative tightening, you need to understand quantitative easing. Quantitative tightening has also been described as a normalization process where a central bank is selling government bonds or letting than mature and allowing them to roll off of their balance sheet.

The price of a bond moves in the opposite direction of the yield. Therefore, when a central bank buys government bonds, it attempts to drive down interest rates. When a central bank sells government bonds during quantitative tightening, it tries to increase interest rates.

What is Quantitative Easing?

The term quantitative easing became a mainstay in the capital markets during the 2008 financial crisis. Central banks purchased treasury securities in the open markets to increase liquidity by forcing up the price of government and agency bonds. Quantitative easing is a form of monetary accommodation that can work in conjunction with reducing lending rates.

Quantitative easing became necessary as the liquidity in the financial system was insufficient to buoy banks' operations during the financial crisis. Before the financial market collapse in 2008, central bankers rarely used quantitative easing to describe excessive bond purchases. Some central banks, such as the European Central Bank, moved their benchmark lending rates below zero to improve liquidity. The central bank also conducted quantitative easing to help provide liquidity to member banks.

The concept of quantitative easing became ingrained in the capital markets during the financial crisis that started in 2008. The situation started as commercial banks began to take subprime loans and package these loans into securities. For example, a bank might purchase 100 loans, and 20 were subprime. The bank would then create a collateralized loan obligation, which is a security that trades in the over-the-counter market. The security's credit quality was considered good since most of the loans in the stake were investment grade.

The securities were marketed throughout wall street, and most of the major commercial banks had departments that sold these securities to clients. The issue was that these securities were based on the U.S. Housing Market continuing to outperform. Once the housing market turned down in 2007-2008, these securities lost significant value.

In 2008 the U.S. central bank dropped its Fed Fund rate to zero from above 4% at the beginning of the year. The central bank decided that instead of dropping the rate below zero, they would begin to purchase government securities to push down interest rates further. While the Fed only controls the Fed fund rate, the overnight borrowing rate, it does not control government securities, including 1-year, 2-year, 5-year, 10-year, and 30-year maturities. Most of the lending in the United States is pegged to the 10-year treasury yield. The Fed decided to purchase quantitative easing securities to reduce that interest rate.

When the Federal Reserve started to purchase government and treasury bonds, they held these securities on their balance sheet. Ahead of the financial crisis, the balance sheet stood near 900 billion dollars. Two years later, in 2010, the balance sheet grew to above 2 trillion. Between 2015 and 2019, the balance sheet remained stable near 4 trillion, and the pandemic hit. The Federal Reserve was forced to cut interest rates to zero and started quantitative easing once again. The Fed's balance sheet more than doubled, nearly reaching 9 trillion.

How Does Quantitative Easing Help and Economy?

If a central bank is purchasing treasury bonds and agency bonds and, in some cases, ETFs, they are helping to increase the price of these products. These purchases help put a floor under the riskier asset and push investors further out on the risk curve. Stock prices hit all-time highs under the most recent quantitative easing, and central bank buying put an artificial tailwind behind stocks and many commodities. Despite the pandemic and the huge job losses that followed because of lockdowns, the sentiment was buoyed because of higher stock and bond prices. When the sentiment is upbeat, consumers will usually spend their money which helps the economy.

Unfortunately, when consumer spending and sentiment become too upbeat, consumers will spend more and more on goods and services, pushing up prices and generating unwanted inflation.

Quantitative easing increases the leverage available in the economic system. Consumers can borrow more at lower rates and therefore afford to spend more.

What is Quantitative Tightening?

The central bank needed to unwind its accommodative monetary policy when the Fed realized inflation was not transitory. The first step was to increase borrowing rates and terminate government and agency bonds purchases. The next step the Fed followed was to allow old maturities to roll off their balance sheet and not replace those bonds. The processes help generate more supply of bonds on the market, putting downward pressure on bond prices. Recall bonds and yields move in opposite directions, so as bond prices move lower, the yield on the bonds moves higher. In forex trading, quantitative tightening buoyed the dollar as yields moved in favor of the greenback.

The Fed then announced they would start selling some of their bonds to help reduce their balance sheet. Since the process began, the Fed has been able to shed about 500 billion dollars from its balance sheet. The goal will be to normalize the balance sheet, reduce the marketplace's liquidity and help decrease inflation expectations. The Federal Reserve is not the only central bank performing quantitative easing and tightening. The European Central Bank and the Bank of Japan have also used this tool.

Not only does quantitative tightening help reduce liquidity as the rate move higher, but it also caps any rallies in bond and stock prices as central banks sell bonds from their balance sheet. The selling of bonds pushes yields on bonds higher, increasing the cost of borrowing. Mortgages have become more expensive, as well as car loans.

As the cost of stocks and riskier bonds fall, investor sentiment begins to sour. Investors who are also consumers will start to spend less on goods and services, and this should bring down inflation.

The risk of quantitative tightening is that the negative sentiment spills over into economic growth, and an economy is pushed into a recession. As stock and bond prices fall, consumers pull back on spending, and growth declines.

Quantitative tightening starts to remove the leverage in the economy. If the leverage is at unsustainable levels, the value of stocks and bonds can decline rapidly and generate a lotf negative sentiment. A negative wealth impact takes hold. Where consumers perceived they were more wealthy than they likely were because they could borrow money at meager rates, the reverse occurs as quantitative tightening takes hold.

Will Quantitative Tightening Continue Once Central Banks Stop Tightening Rates?

The answer is yes if we define quantitative tightening as the maturing of securities and not repurchasing them back. Central banks used quantitative easing as an emergency mechanism to propel economic growth in the wake of the pandemic. The volumes of securities needed to buoy growth were substantial. Governments also used fiscal stimulus, including tax breaks and subsidies, to help consumer spending. According to the CME Fed Watch Tool, the likely terminal rate by the Federal Reserve is 5% which they will likely hit by May 2023. It will take much longer for the Fed to unwind the 9 trillion dollar balance sheet it put together to fend off economic contraction during the pandemic and the financial crisis.

The Bottom Line

The term quantitative tightening refers to the opposite of quantitative easing, which is adding securities to your balance sheet to reduce government yields and make riskier assets more attractive. During the financial crisis in 2008-2009 and again during the first couple of years following the pandemic, central banks used quantitative easing to help buoy consumer spending and growth. By providing investors with a wealth effect, central bankers provided the markets with robust leverage volumes to enhance their stock market gains.

The process worked very well when combined with fiscal stimulus in the United States. Growth served along with wages, eventually leading to inflation. Initially, the Federal Reserve believed that inflation was transitory, but ultimately, they increased the lending rate to halt inflation and growth.

The Fed also needed to reduce liquidity by unwinding the quantitative easing during the pandemic. Their balance sheet had ballooned to nearly 9 trillion dollars, and a decision was made to allow securities to mature and to sell parts of their assets. Quantitative tightening should work in conjunction with rising borrowing rates to reduce growth and inflation expectations.

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