Quantitative tightening

Posted By Darren Winters on Jan 24, 2019


Quantitative tightening

The Fed’s Quantitative tightening became a major talking point for traders/investors particularly in the final quarter of 2018. What is Quantitative tightening?

Quantitative tightening is a contractionary monetary policy applied by the Fed to reduce the amount of liquidity, sloshing around the financial markets with the aim of unwinding the everything bubble.

So Quantitative tightening is, in essence, the reverse of Quantitative easing an expansionary monetary policy which aims to increase the money supply, thereby inflating asset prices and (in theory) stimulating the economy.

Quantitative tightening for traders/investors is like the fuel gauge on the motorist’s dashboard

Quantitative tightening

When the fuel gauge reads empty the engine soon stumbles the rev meter and speedometer needles both drop rapidly and the automobile grinds to a halt. So one  simple explanation why stocks fell, particularly in December is that Quantitative tightening was increasing.

The chart here shows quantitative easing reaching a peak of $2.6 trillion in March 2018 then there is a huge drop to under $1 trillion in the second half on 2018.

By the start of the fourth quarter of 2018, the Fed had finished raising the caps on monthly roll-off of its balance sheet to the full $50bn per month. However, on many months the Fed’s balance sheet does not actually shrink by this full amount which depends on the redemption schedule. The end-Q4 markets also experienced some of the largest volatility and drawdowns in nearly a decade.

But notice how Quantitative tightening, the reduction of assets held on the Fed’s balance sheet actually picks up in the first few weeks of 2019, according to the chart.

So will quantitative tightening, which is expected to be part of the Fed contractionary policy in 2019 be “like watching paint dry,” according to the former Fed Chair Janet Yellen?

Absolutely not. The Fed’s balance sheet reductions were a major market event causing ‘taper tantrum’, in 2013 which rocked financial markets.

So it stands to reason that if you jam a wire pin down a live socket you’ll get a shock and if you repeat the action again you are going to get another nasty shock.

Put simply, the ramping up of quantitative tightening is likely to cause another market shock in 2019

Admittedly no two events are identical because the conditions are rarely identical. But I would argue that significant changes have occurred since 2013. The world is less united and there is an unmistakable geocentric shift from the dollar. Iran intends to switch to a non-dollar trade exchange with China, India, Russia, and Turkey. China’s Belt and Road initiative seeks to internationalize the yuan. The Petro-Yuan now exists which is a rival to the Petro-Dollar. In Europe, EU army plans “to defend against Russia (main supplier of Gas to central Europe) and the US” is no longer a secret. Moreover, Asian bond investors have returned to Europe as the US loses luster.

In short, Quantitative tightening, if implemented in 2019, will be anything “like watching paint dry”

The Fed balance sheet reductions could be the catalyst for something more acute than that experienced in 2013, bearing in mind this geocentric shift.

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