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More Truth Behind Quantitative Tightening (QT)


  • The composition of the Federal Reserve balance sheet is skewed towards short-dated maturities.
  • The majority of asset sales will come on the short-end and push up short rates more than long rates.
  • Increased short-term interest rates will slow the economy and potentially cause long-term rates to fall, further flattening the yield curve.

Why QT Will Flatten The Yield Curve

This week, we saw an inversion in the yield curve, a long-standing precursor of a recession. The inversion was not in the traditional treasury curve but in the breakeven spreads. The spread between the 30-year breakeven rate and the 5-year breakeven rate inverted this week for the first time since 2008.

In this piece, I will discuss why the yield curve is flattening through the lens of the Federal Reserve Quantitative Tightening (QT) program. There are a lot of misconceptions surrounding the QT program and a flattening or inversion of the yield curve makes perfect sense once the composition of the Federal Reserve balance sheet is properly understood.

The balance sheet of the Federal Reserve is skewed towards short-term maturity treasuries. Many of the bond bears dislike long duration bonds because the Federal Reserve is selling bonds as if that means all bonds, so therefore, all rates must rise. This could not be more incorrect and a simple look at the Federal Reserve balance sheet makes the flattening of the yield curve quite logical.

Once the composition of the balance sheet is understood, it becomes quite clear that if the Federal Reserve continues on their QT path, the yield curve will continue to flatten, as it has been, and likely invest in several months. The question then becomes is the inversion of the yield curve the cause of a recession or symptom of a recession. In other words, if the Federal Reserve inverts the yield curve, as they are likely to do with the QT program, will that cause a recession in 2019?

As a stand-alone, 'yield curve inverting means recession', I would tend not to agree. The economic data is slowing materially, the growth in the money supply (M2) is contracting rapidly and bank loan growth is near

This article was written by

Eric Basmajian profile picture

Eric Basmajian is the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices. He was previously an analyst at a quantitative hedge fund.

Eric leads the investing group EPB Macro Research where he applies investing strategies with the understanding that when there is an economic inflection point, company fundamentals don’t matter, technical trends break down and investors are blindsided. His analysis helps investors position their portfolios to avoid losses and maximize gains during changing economic conditions. Learn More.

Analyst’s Disclosure: I am/we are long TLT, IEF, SHV, GLD, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (33)

great article
In a nutshell, the US got Europe and Japan into QE and then resumed regular economic policy (pre-QE) that everybody forgot. QE was only needed to avoid hard landing in 2008-9. As more than 95% TARP assets are now recovered, QE is simply not necessary. That would make yen a lot less stable, highest debt to GDP ratio. And euro - it is, by definition, a virtual currency since 1960s. Eurozone will suffer most.
GeRM profile picture
An interesting read here - http://read.bi/2tEHLrT

"Then in a June 2017 addendum, the Fed laid out a clever plan to pare down its balance sheet calling for a cap on how many bonds would be allowed to mature without being reinvested. This cap, which starts at $10 billion worth of securities per month and gradually increases each quarter to $50 billion per month, allows the Fed to continue reinvesting nearly all principal and interest payments—minus the size of the cap—while also reducing the size of its balance sheet."
"For example, in in January 2018 approximately $27 billion in U.S. Treasury bonds will come due. With the cap, the Fed will be reinvesting $21 billion in the Treasurys that Secretary Mnuchin issues. In February, if the cap is not raised, the Fed will buy $42 billion in Treasury bonds, making it a QE-type purchase even though balance sheet reduction is well under way. Although the exact cap may change depending on other market conditions, the deliberate pace of normalization, at the outset, should cause the yield curve to flatten as the Fed reinvests in long term securities issued by Treasury."
"The Fed will be rolling maturing securities into Treasury issues thereby allowing Treasury to essentially reconstruct the duration of the Fed's balance sheet by determining what bonds will be issued on a particular day. Treasury thus can issue long-term debt without having to increase yields to attract substantial new investment. In effect, the Fed's normalization plan will allow interest rates to rise slowly relative to the short rates and prove a source of inexpensive funding for Treasury activities."
GeRM profile picture
HI EB ... some nit picking details
From FRED data on 03/12/2018 @ 10:00AM
5-Year Breakeven Inflation Rate (T5YIE) shows 2.08
30-year Breakeven Inflation Rate (T30YIEM) shows 2.18
These aren't inverted ... where did your data come from?
Thanks for article. An interesting perspective
Salmo trutta profile picture
That's one reason for "Libor-OIS Blows Out The Most Since 2012"
The interest the government pays to the fed comes back to the government, because the fed is a government owned non-profit organization. I read an article recently from a very respectable source, that the fed is going to replace the short term bonds with very long term (similar to operation twist done in the recent past), effectively increasing its maturity weighted balance sheet. The flattening of the yield curve confirms this information.
If Feds not sell the bonds, that actually straighten author's argument. Because longer term bond (purchased as part of QE) won't mature now, so that is not the reason that caused the bond market massacre.

I heard there is lesser foreign government investment in long time bond(they typically hold to maturity), but more individual investors, they are more sensitive to price fluctuation, and easier on the short side? maybe there is why the TLT consistently going lower?
TLT has been stable around 118 for weeks, and may well have bottomed for now. (Meaning the yields for long-dated Treasuries have topped for the near-term.)
Yeah, I guess shorting to speculate is also subjective to expiration/squeezing. as mentioned in one of the other author's articles.
Lord Hamlake's Chauffeur profile picture
"Rather than sell the bonds outright, which could roil markets, the Fed plans to gradually trim its holdings by not reinvesting the proceeds from some of the assets as they mature." — US Today, Sep. 20, 2017. Nobody is selling their bonds.
turb0kat profile picture
yeah sort of invalidates the entire article that the author bases it on the idea of Fed "bond sales"...
Think about it. When a bond matures, the government has to come up with the money to pay off the balance, i.e. has to borrow on the open market, i.e. sell bonds to pay it off. Not reinvesting the matured bonds leads to bond sales not by the fed, but by the government. If the fed reinvested the balance of the matured bond, no money is due from the government. Not reinvesting the matured bond, reduces the money supply, because the fed effectively removes this money from the economy.
Eric Basmajian profile picture
Nice! Thank you!
This from the Harvard Business School: The U.S. Political System Has Been 'Hijacked'

jprizzuto profile picture
from jprizzuto: the u.s. politically system needed to be hijacked.
How do you know if the Fed won’t sell longer term assets first then work their way to the shorter assets once rate raising is over?
The Fed isn't selling assets with QT. Rather, they are waiting for them to mature, and then not buying replacement assets.
Salmo trutta profile picture
I was going to say the same thing in reference to:

"Nearly 75% of the bond sales from the Federal Reserve will come with maturities 10 years or less."

I think many agree with Eric's scenario, but would express it differently. But it seems from the comments that a large # of SA participants have little experience with asset speculation. I would say most wannabe speculators desperately need his professional guidance.

See Daily Treasury Yield Curve Rates:

The 1 mo!

As I said:

Notice the rise in the 1 mo rate. That reflects “tight” money during a period of decelerating inflation. Expect stocks to fall further (at least until the next payment’s “rotation”).
Mar 6, 2018. 09:11 PMLink

Like I repeatedly say, if xxx don't fall there's a new paradigm (not a new decoupling). And no, Friday didn't surprise me.
When do you think the next QE starts? Will it be called "Abnormalization"?
mmkkgg profile picture
maybe SPY because of tax cut stimulative effect?
If you are looking for a slowdown and possible recession why are you long SPY and GLD?
Eric Basmajian profile picture
Look at all holdings. You also don’t know the weighting’s. Only subscribers do
Disagree with this article? Submit your own. To report a factual error in this article, . Your feedback matters to us!

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