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Liontrust’s Phil Milburn: Fed minutes — QT is a double-edged sword for the bond markets

As minutes released last night showed the Federal Reserve hinting at starting quantitative tightening, Phil Milburn, co-head of the Liontrust Global Fixed Income Team comments on what this means for markets:

“Did we learn anything from last night’s Fed minutes? Probably yes, but with wiggle room for the Federal Reserve members to change their minds between now and their next meeting in May. 

Firstly, from both the hawkish language of the minutes and recent comments from dovish voters such as Brainard, a 50-basis point hike in May should be anticipated unless some left field event materialises. 

The Fed did not commit to starting quantitative tightening (QT) at their May meeting, but they did very strongly hint it would be the case. They did disclose the size of the “caps” under which QT would operate; $60 billion per month for US Treasuries and $35 billion for agency MBS (mortgage backed securities). As a reminder, the caps are the maximum the Fed will let run off in any month, any maturities above the caps get reinvested. Still, a pace of $95 billion a month will lead to a shrinkage in the $9 trillion balance sheet of over $1 trillion per annum. When these caps are introduced, probably in May, they will be “…phased in over a period of three months or modestly longer if market conditions warrant. 

The minutes showed the Fed is prepared to go faster on balance sheet reduction, pursuing active sales of MBS once the process has started. In their words “…after balance sheet runoff was well under way, it will be appropriate to consider sales of agency MBS to enable suitable progress toward a longer-run … portfolio composed primarily of Treasury securities.

The impact of QT is a double-edged sword for the bond markets. Clearly, when the biggest buyer turns in to a net seller this is a negative for the US Treasury market. Conversely, the more QT there is and faster the pace the less the need for interest rate hikes. On balance the approach to QT should create a little yield curve steepening; short dated bonds being supported by expectations of a slightly lower peak in interest rates and longer dated bonds struggling from the change in the demand/supply dynamic. 

Finally, how much QT should we anticipate?  The Fed has not set a target, my best estimate is about $3 trillion. I have two methods for estimating this, and both arrive at about the same answer. In the previous bout of QT the Fed shrank its balance sheet by about 35%, so $3 trillion out of $9 trillion would be consistent. Or one can look at the percentage of GDP that the Fed wants its balance sheet to be, something in the low 20s region seems to be their comfort zone. US GDP last year was about $23 trillion, in another three years US GDP will be approaching $30 trillion; 20% of that is about $6 trillion stock of QE left so consistent with $3 trillion shrinkage or QT over the next few years.”

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