How Quantitative Tightening (QT) Might Impact Investors

By:Tim Bennett
Central Banks are threatening to throw monetary policy into reverse gear to fend off inflation. Tim Bennett looks at how and asks what it could mean for investors.
After years of interest rates being lowered by Central Banks and additional money being created via Quantitative Easing (QE) in the wake of the financial crisis of 2007/8, investors are now waking up to a whole new reality. In short, Central Banks are starting to throw policies designed to stimulate growth and demand into reverse. So, here I take a quick look at what is being labelled “Quantitative Tightening” or “QT” and explain what it may mean for your investments.

Stimulating an economy

First the backdrop. Until pretty recently, Central Banks had been engaged in a “race to the bottom” when it came to interest rate policy. Fearful that growth would slow and even that major financial institutions might collapse, they slashed interest rates in unison. That is evidenced, in the UK, to a historically record-low rate of just 0.25%.

On top of that they also “printed” money via Quantitative Easing (QE). In a nutshell, this involved them making more-or-less compulsory purchases of government and corporate bonds (or “IOUs”) from institutions such as pension funds and life assurance companies in return for additional electronic liquidity (“money printing” as it became known). The idea was that this extra cheap funding would find its way out into the economy via loans to companies and consumers and/or asset purchases. Many ascribe at least some of the recent stock market boom to this process. More recently though, the Federal Reserve has been leading the way in slamming both of these monetary gears – interest rates and QE – into reverse.

Interest rate policy

The impact of lowering, or now raising, a Central Bank rate can be summarised as follows;
Now that signs of growth can be seen across many major developed economies and as asset prices for things like equities have boomed, the Fed is keen to reduce the chances of an inflationary spike. Lower rates, whilst a crude tool that suffers from both a timing lag and a degree of uncertainty about the eventual impact, are one way to go about it. However, there is another which they have signalled that they are keen to try soon and probably this year.

The basics of QT

The US Federal Reserve, in particular, has signalled recently that it may attempt to unwind its huge program of monetary stimulus by not just shutting off QE (which it did a while ago) but actually trying to reverse it. They say they will do this by allowing a chunk of the debt they currently own thanks to previous purchases, issued by a mixture of the government and corporates (in the form, for example, of mortgage-backed securities) to simply mature. At that point the Fed will receive money from the issuer as a final maturity (or “redemption”) payment and they will then simply cancel it – in effect the money will evaporate. The Fed can do this simply because it is a Central Bank and therefore the ultimate control over the quantity of money, whether physical or electronic, in circulation in the US economy, resides with them.

Over time, the Federal Reserve hopes to “shrink its balance sheet” in this way and reduce the $4trn debt pile it has accumulated through its debt purchases that were part of the previous QE program. It all sounds simple enough, but it is not without risk.

What could go wrong?

The Fed will be hoping to effect a steady withdrawal of its previous stimulus such that financial markets and asset prices are not unduly affected, as summarised below;
The problem, however, is that this type of QT program, on the sort of scale the Fed is talking about over the medium term has never been done before. What’s more, the effects will be hard to predict. We have, for example, already seen a “taper tantrum” from the bonds market the last time the Fed tried to reign in QE. In a worst case scenario, QT could be misjudged (in terms of the amount) or mistimed (i.e. implemented as growth flags) and might trigger a George Soros-style loss of confidence and an asset-price collapse across everything from bonds to equities and even property. That’s why many investors will be watching this space carefully from now on and hoping that Philadelphia Fed President Patrick Harker is right to say that QT will infact be “the policy equivalent of watching paint dry”.