💎Pika World Pulse: Understanding Quantitative Tapering💎

It’s yet another sell on the rally! Just as we have a friendly Uncle Powell singing melody for a relief rally, the Fed Vice-Chair Brainard dropped another bomb to the market where she consider a quicker rate hike and possibly balance sheet runoff that spook the markets once again. Nasdaq dived down despite the treasury yield giving support to the market. 

🧨A ballon floating🥊

Since the onset of the pandemic, the Fed’s balance sheet had increased dramatically, to hit $9 trillion and is still growing. Therefore, with the reduction in monetary support, investors naturally turn their attention to the prospects of central banks reducing the asset portfolio. 

The December FOMC meeting minutes had confirmed the debate on the normalisation policy for the balance sheet. Moreover, the discussion was seen as more robust than anticipated. 

During Uncle Powell’s confirmation hearing, he spoke about such tightening prospects soon. 

💰Balance Sheet has a profound effect🎢

With such a large balance sheet, the consequences of a smaller balance sheet goal are more important than interest rate hikes. Quantitative tightening is the opposite of the QE, which we know. 

In Quantitative Tightening (QT), the Fed will receive the principal sum from the treasury holdings but will not reinvest them into new treasuries. The Fed is likely to tread this path carefully because it involves the draining of liquidity in the bank reserve balances. The Fed may not know the exact amount needed for the financial system to function correctly, thus is unlikely to take an aggressive stance. 

In 2017, the Fed had started the QT at an initial pace of $6 billion and climbed to $30 billion until mid-2019 when there was a sudden sharp rise in the repo rates- the rate at which investors exchange their Treasuries for cash for short term money needs. 

💡How does it work?🔭

Consider the following. When the Fed receives $20 billion in principal repayment of its treasury holdings and embarks on a $15 QT program, it will essentially roll over $5 billion to buy newly issued treasury bills. Hence, it drains a total of $15 billion from the financial system. 

📮Our Outlook🪜

Pika World does not believe the Fed will remove all of its QE, given the economy is still prone to downside risk on Omicron. Moreover, the withdrawal is likely to impact asset prices that had expanded aggressively. 

Hence, a Fed’s measured step in the balance sheet’s normalisation will soothe investors nervousness and prolong the economic expansion as Uncle Powell spoke about. 

We hope you enjoy this edition and see you in the next one!

Cheers, 

Pika Nat