Authored by: TJ Scavone

Quantitative Tightening Raises the Risks for Markets

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With inflation running at multi-decade highs, monetary policymakers are united in one of the most aggressive tightening campaigns in decades. Most central banks have already significantly increased policy rates this year, and some are unwinding their massive balance sheets, also known as quantitative tightening (QT). In this paper, we review what is known about the current state of central banks’ balance sheets and their operations, discuss some known uncertainties of QT’s impact on financial markets, and consider QT in the context of the current market environment.

Fed Raises Rates and Begins Balance Sheet Run-off

Yesterday, the Federal Reserve announced it would raise the target range for the Fed funds rate 50 basis points (bps) to 0.75%–1.00%. It also formalized plans to reduce its $9 trillion balance sheet starting June 1, with an initial monthly cap of $47.5 billion, rising to $95 billion per month on September 1.

Developed Markets Monetary Policy and Rates Outlook

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Government bonds have sold off to start the year as central banks tighten policy in response to inflation pressures. The rise in yields this year may meet some resistance in the near-term, but likely has more room to run given the economic backdrop and policy trajectory. Of course, the war in Ukraine and its impact on the economy will be a key driver of rates for the duration of the conflict.

US Inflation Tests New Heights but Should Ease in 2022

US consumer prices increased 7.0% year-over-year in December, which is the fastest annual rate since 1982, according to government data released today. We expect US inflation will moderate in the coming months, in line with consensus forecasts, but we anticipate it will settle in a higher range than the previous cycle.

Inflation Pressures Central Banks to Begin Normalizing Policies

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This week, the Federal Reserve, the Bank of England, and to a lesser extent the European Central Bank all acted to tighten monetary policies. These tightenings came as inflationary pressures have surged in many countries and as other central banks have looked to rein in simulative policies. But, when combined with above-trend growth expectations next year and central banks’ likely cautious tightening approach, we suspect financial conditions will likely remain accommodative and supportive of risk assets.

Government Bond Yields Are Likely to Rise as Central Banks Remove Support

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Long-dated government bond yields rose in 2021 on strong economic growth and surging inflation. Central banks have maintained their easy money policies despite the rapid recovery in economic conditions, likely keeping yields lower than they would have been otherwise. This may soon change now that several major central banks are starting the process of dialing back support.

Will Talk of the Fed Tapering Cause Another Bond Tantrum?

No. While the Federal Reserve’s discussion of tapering asset purchases signals a shift toward tighter monetary policy, both the Fed and markets learned valuable lessons from the 2013 Taper Tantrum; the impact on bond yields should be limited.