Some market players are beginning to fear a major policy mistake by a central bank


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

Brendan McDermid | Reuters

The US Federal Reserve took an aggressive note last week as it fights inflation through monetary policy, but analysts are concerned about the potential threat of its ongoing tightening strategy.

Fed Chair Jerome Powell warned the US economy will face “some pain” if the central bank continues to raise interest rates aggressively, prompting markets to sell again on the heightened prospect of a recession.

Markets around the world sold off amid apparent confirmation that monetary policy tightening is being pushed forward, likely exacerbating the risk of a recession as policymakers focus on Fed Funds rate as the main tool to fight inflation.

However, in a research paper Tuesday, analysts at London-based CrossBorder Capital argued that the “quantitative liquidity dimension” is being overlooked, where the Fed’s balance sheet reduction — or quantitative tightening — has an asymmetric impact on the economy.

“The Fed sees QT/QE working as an ‘air conditioner’ buzzing in the background, but we see QT as a wrecking ball that will eventually turn into another QE,” CEO Michael Howell said in the note.

CrossBorder warned ahead of Powell’s address in Jackson Hole, Wyoming, that the risk of a “major imminent policy flaw” from the Fed’s course of action, particularly the “impact of excessive QT on financial stability,” was mounting.

Quantitative tightening

Quantitative tightening is a monetary policy tactic used by central banks to reduce liquidity and shrink their balance sheets, usually by selling or maturing government bonds and taking them off the bank’s cash balances.

CrossBorder Capital believes that central banks are sucking too much liquidity out of financial markets too quickly, and Howell pointed to a recent aggressive shift by some European Central Bank policymakers, which he says could lead to euro instability and ultimately a liquidity turn of central banks in 2023.

“Our concern is that QE/QT has disproportionate effects on financial stability, with the Fed’s proposed balance sheet contraction of nearly a third, equivalent to about 5% points added to Fed Funds,” said Howell,

“At some point in 2023, the Fed will be forced to flip to get its balance sheet back up and the US dollar down. Until this point is reached, the coming months will see a larger QT (quantitative tightening). should deter the markets.”

Concerns about QT were echoed by Mazars Chief Economist George Lagarias, who urged traders and investors to forget what they heard from Powell in Jackson Hole and instead focus on Fed assets as a single leading indicator.

The Fed increases quantitative tightening from $45 billion to $95 billion. Meanwhile, the ECB will end its quantitative easing in September, albeit with a program to reduce the fragmentation between interest rates in highly indebted and less indebted Member States.

“Shall [the Fed’s cap increase] rapidly sucking money from the markets? His true intentions will be shown in that area, not in policy speeches,” Lagarias said on Tuesday.

“In the meantime, investors should be concerned about the longer-term ramifications of the Fed’s stance. The slowdown could turn into a deep recession. Inflation could turn into deflation.”

He noted that emerging markets and US exporters are already suffering from the strong dollar, while consumers are “at the end of their line”, especially in the current circumstances where central banks are aligning their policies on wage suppression during the cost of living crisis.

“The time when central bank independence is questioned may not be so far off,” Lagarias said.

Underestimating the impact of QT?

When the Fed rolled back its bond portfolio in 2018, it sparked a near repeat of 2013’s infamous “taper tantrum” — a sharp sell-off in the markets, prompting the central bank to moderate policy and slow the pace of Treasury sales. to slow down.

“The central banks claim that they can afford to reduce their bond holdings because the commercial banks have adequate reserves and the central bank doesn’t need as much of government bond issuance,” said Garry White, chief investment commentator at the U.K. investment manager. Charles Stanley, said in a note ahead of Powell’s Jackson Hole speech.

“More of that could be held by the private sector at the expense of their bank deposits. Central banks may be underestimating the impact of substantial quantitative tightening.”

Markets have not priced in the effects of quantitative tightening, says AJ Oden of BNY Mellon

Governments will aim to sell significant amounts of debt in the coming years, with fiscal policy becoming unprecedentedly accommodative in the face of the Covid-19 pandemic in early 2020.

White suggested that the end of central bank bond purchases will force governments to pay higher interest rates to service their debts.

“If the central banks turned into sellers of government bonds, the difficulties would worsen,” he said.

“For now, the main goal of the Fed and the ECB is to end new bond buying and allow portfolio outflows as governments have to repay bond debt at maturity.”

Beat Wittmann, chairman and partner at Zurich-based Porta Advisors, also recently warned of the growing risk of a “major financial accident” leading to market capping later in the year.

“The list of weak link candidates is quite long and includes zombie-type European universal banks, LBO [leveraged buyout] Financed companies, over-indebted shadow bankers and over-indebted emerging market government bonds,” Wittman said.

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