Will Quantitative Tightening Overwhelm the Markets?

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Inflation is running hot, and the market is projecting seven rate increases this year alone. As if that is not concerning enough for bond investors, the Fed is hinting at draining liquidity via balance sheet reduction, i.e., quantitative tightening (QT).

At Jerome Powell's post-March 16, 2022, FOMC press conference, he stated: "It's clearly time to raise interest rates and begin the balance sheet shrinkage." Based on further comments, Powell wants to start normalizing the Fed's balance sheet and drain liquidity as early as May.

Since March of 2020, the Fed has bought about $3.5 trillion in U.S Treasury securities and $1.5 trillion in mortgage debt. The gush of liquidity from the Fed's quantitative easing (QE) program caused the U.S. Treasury to run massive pandemic-related deficits. Buying over half of the Treasury's debt issuance in 2020 and 2021 limited the supply of bonds on the market and put upward pressure on interest rates.

Equally important to the Fed, QE comforted investors in March of 2020 and further boosted many asset prices throughout its existence.

With QE finished and QT on the horizon, I answer a few questions to help you better appreciate what QT is, how it will operate, and discuss how draining liquidity will affect markets.

What are QE and QT?

QE is the process in which the Fed purchases Treasury and mortgage bonds from banks. In exchange, the banks receive reserves from the Fed. These reserves are not cash, but are the basis by which banks can lend money. As such, there is an indirect connection between QE and money printing.