Hot Topic: Trading Quantitative Tightening

Market Analysis /
24 Feb 2019

QT – what is it, why is it happening, and can I trade it?

QT - or Quantitative Tightening – is likely to be an increasingly commonly referenced theme over the summer. But what is it and how can you think about trading it?

In the wake of the credit crisis a decade ago, the Federal Reserve – along with many other central banks – embarked on a series of aggressive monetary stimulus measures, designed fire growth into their respective national economies. Interest rates were cut right back but in addition, entities like the Fed embarked on a bond buying spree, designed to keep markets moving and ensure that sufficient credit was available at a meaningful price.

In three bouts of Quantitative Easing – or QE – the Fed amassed a balance sheet of corporate bonds worth over $4 trillion by 2014. Largely these bonds were rolled over at maturity, so when principal repayments were made, this money was reinvested in more bonds. However, from 2017 the Fed started to wind in the process – the so called Quantitative Tightening - by $50 billion a month. This can be seen in the chart below.

The problem is, such tightening is seen to work best as underlying interest rates are rising. The Fed funds rate started increasing in December 2017 when it was moved up to 0.5%. Now that the Fed has seemingly called time on ratcheting up monetary policy and indeed there’s some speculation that interest rates will need to fall before the year end, a pause in QT seems about due. What’s more, if the US economy slows too quickly then the bond buying bonanza may be necessary once more.

As was noted in a previous Hot Topic (insert relevant link to Trading US inflation 11th Feb), as the balance sheet falls, the expectation is that inflation will rise. This is because cash flows from the banks back into the wider economy. Lower interest rates will however act as a far blunter tool for fuelling inflation, hence the reason the market expects time to be called on this approach.

 

TRADE OPPORTUNITIES

So, what to look for? The minutes show us that the Fed is increasingly talking about QT in its routine meetings, but at some point – possibly as soon as the summer – they are expected to call time on the process. This presents two clear opportunities.

  • The US Dollar should weaken against other currencies. The consequences here do however need to be filtered out from the safe haven allure of the US dollar, which could well be in play given the worsening global economic outlook in general
  • Perhaps more directly, ending QT should mean equities will find fresh support. The chart below illustrate clearly the effect of QE on supporting the rally seen by US stocks since the credit crisis. This upward momentum expired in 2018 when QT started, so an outperformance of US indices versus global peers could be observed.

It seems inevitable that QT will be a dominant theme in the months that lie ahead. However it’s important to bear in mind that with US interest rates suitably inflated from post-crash lows, the Fed have a far wider range of ammunition at their disposal to try and fend off the next recession when compared to reserve banks in many other G10 countries.

 

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