Some market players are beginning to fear a critical policy mistake from the central bank

A screen displays a Federal Reserve rate announcement as a trader works (inside a post) on the floor of the New York Stock Exchange (NYSE) in New York, June 15, 2022.

Brendan McDermid | Reuters

The US Federal Reserve last week took a hawkish tone on fighting inflation through monetary policy, but analysts are concerned about the potential threat of an ongoing tightening strategy.

Federal Reserve Chairman Jerome Powell warned that the US economy will face “some pain” as the central bank continues to aggressively raise interest rates, prompting markets to sell again as the possibility of a recession grows.

Markets across the world were sold off amid the clear assertion that monetary tightening is being loaded to the fore, likely to exacerbate the risk of a recession as policymakers focus on the fed funds rate as a key anti-inflation tool.

However, in a research note on Tuesday, analysts at London-based CrossBorder Capital argued that the “quantitative liquidity dimension” is being overlooked, with the Fed’s balance sheet cut – or quantitative tightening – having a disproportionate effect on the economy.

“The Fed sees QT/QE acting like ‘air conditioning unit’ buzzes in the background, but we see QT as a wrecking ball that will eventually reverse into another QE,” CEO Michael Hoyle said in the note.

Cross Border warned ahead of Powell Jackson Hole’s speech that the risk was growing of a “big upcoming policy mistake” from the Fed’s course of action, specifically the “excessive QT effect on financial stability”.

quantitative tightening

Quantitative tightening is a monetary policy tactic used by central banks to reduce liquidity and hold their balance sheets, usually by selling government bonds or allowing them to mature and taking them out of bank cash balances.

CrossBorder Capital believes that central banks are sucking up too much liquidity from financial markets too quickly, and Hoyle pointed to the recent hawkish shift by some ECB policymakers, which he said could lead to euro instability and ultimately a liquidity shift from central banks. in 2023.

“Our concern is that quantitative easing/QT will have significant impacts on financial stability, as the proposed contraction of one-third of the Fed’s balance sheet equals about 5% points added to the federal funds,” Howell said,

“At some point in 2023, the Fed will have to focus on raising its balance sheet again and the US dollar falling. Until that point is reached, the next few months will see a bigger QT (quantitative tightening). That should scare the markets.”

Concern about the QT was echoed by Mazars chief economist George Lagarias, who urged traders and investors to forget what they heard from Powell at Jackson Hole and instead focus on Fed assets as a single leading indicator.

The Federal Reserve increases the cap on quantitative tightening from $45 billion to $95 billion. Meanwhile, in September, the European Central Bank ended quantitative easing, albeit with a program in place to limit the split between borrowing rates in heavily indebted and less indebted member states.

“Will [the Fed’s cap increase] Withdrawing money from the markets at a rapid pace? Lagarias said on Tuesday that her true intentions would appear in the field, not in policy speeches.

“In the meantime, investors should worry about the long-term implications of the Fed’s stance. The slowdown could turn into a deep recession. Inflation could turn into deflation.”

He noted that US emerging markets and exporters are already suffering from the strength of the dollar, while consumers are “on the end of their limitations”, especially in the current circumstances in which central banks are preparing their policies towards wage cuts during the cost of living. crisis.

Lagarias speculated that “the time when the independence of the central bank is called into question may not be too far away.”

Minimizing the effect of Qt?

When the Fed brought back its portfolio of bonds in 2018, it triggered the infamous “taper tantrum” — a sharp sell-off in the markets, prompting the central bank to moderate policy and slow the pace of Treasury sales.

“Central banks argue that they can reduce their bond holdings because commercial banks have a lot of reserves and don’t need the central bank to hold a lot of government bond issues,” said Gary White, senior investment commentator at UK Investment Manager. Charles Stanley said in a note before Paul Jackson Hole’s speech.

“The private sector can hold more of that at the expense of its bank deposits. It may be that central banks are underestimating the impact of significant quantitative tightening.”

Markets haven't determined the effects of quantitative tightening, says BNY Mellon's AJ Oden

Governments aim to sell large amounts of debt in the coming years, as fiscal policy becomes unprecedentedly loose in light of the Covid-19 pandemic in early 2020.

White noted that the end of central bank bond buying would mean governments would pay a higher interest rate to offload their debt.

“If central banks turn into sellers of government bonds, the difficulties will increase,” he said.

“For now, the main objective of the Fed and the European Central Bank is to end all new bond purchases and allow portfolios to flow as governments have to repay bond debt at maturity.”

Pete Whitman, chairman and partner at Zurich-based Porta Advisors, also recently warned of the growing risk of a “major financial accident” causing the market to capitulate later in the year.

“The list of candidates with weak links is rather long and includes the zombie-type European global banks, LBO [leveraged buyout] corporate financiers, over-leveraged shadow banking players, and the supremacy of highly indebted emerging markets.”

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