The beginning of so-called quantitative tightening commences on Wednesday as the Fed lets bonds mature off its $9T balance sheet without replacement. It's a big step for a central bank that conducted unprecedented bond purchases from March 2020 to March 2022, which were intended to blunt the economic fallout from the coronavirus pandemic. The pullback comes at a time when the Treasury market is already grappling with periods of volatility and low liquidity, and there are many unanswered questions about the effects of the new policy regime.
Snapshot: Yields should technically move higher in response to QT, while the curve should steepen, due to a tightening of financial conditions and money supply. However, the direction of yields is also highly dependent on other economic factors, like expectations of Fed interest rate hikes, the U.S. economic outlook or greater regulatory constraints. Other feel that any outsized impacts will rather show up in money markets or financial market plumbing, or that effects on liquidity are at least a few quarters away.
"It's going to be very gradual... It's just too soon to know what if anything the impact is going to be from QT," said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. "I don’t think we know the impacts of QT just yet, especially since we haven't done this slimming down of the balance sheet much in history," added Dan Eye, chief investment officer at Fort Pitt Capital Group. "But it's a safe bet to say that it pulls liquidity out of the market, and it's reasonable to think that as liquidity is pulled out, it affects multiples in valuations to some degree."
Go deeper: The latest central bank story comes as the U.S. grapples with persistent red-hot inflation, which triggered a rare meeting between President Biden and Fed Chair Jerome Powell on Tuesday. Treasury Secretary Janet Yellen, who previously served as Fed Chair under the Obama administration, was also at the gathering, but later admitted that she "was wrong about the path inflation would take" and that it wouldn't pose a long-term problem. "There have been unanticipated and large shocks to the economy that have boosted energy and food prices, and supply bottlenecks that have affected our economy badly," Yellen told CNN's Wolf Blitzer. "At the time I didn't fully understand, but we recognize that now."
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