Wednesday’s Federal Reserve policy decision maintained interest rates at the same level since July 2023, which did not surprise investors. However, the announcement of a significant reduction in the quantitative tightening (QT) program starting in June caught the attention of savvy traders. QT involves the selling off of assets by the Fed to decrease money supply and increase interest rates.
Following the news, US Treasury yields experienced a decline, with both the 10-year and 2-year yields dropping by 0.05 percentage points. The Fed's decision to curtail its QT program marks a shift from its previous strategy.
The Fed had initially purchased a substantial amount of government-backed bonds between 2020 and 2022 to support economic recovery post-pandemic-induced recession. However, as inflation surged, the Fed began unloading these bonds in mid-2022 to counter the impact on interest rates in sectors like housing and auto sales.
The current QT strategy involves allowing up to $60 billion in Treasuries to mature monthly without replacement, thereby reducing the money supply in the economy. While this move aims to exert downward pressure on prices, it also poses potential risks by altering liquidity levels and redirecting funds.
JPMorgan Chase CEO highlighted concerns about the scale of QT, emphasizing that the current pace drains over $900 billion in liquidity annually. The practice could lead to higher interest rates and tighter monetary conditions, similar to the challenges faced during the 2019 QT implementation.
In 2019, the Fed's QT program resulted in a shortage of reserves for some banks, triggering a repo crisis with unusually high overnight loan interest rates between banks. To address this, the Fed had to intervene by providing liquidity to stabilize repo rates.
Fed Chair Jerome Powell aims to avoid a repeat of the 2019 scenario and indicated a forthcoming scaling back of QT during the recent press conference. The Fed's decision to reduce the rate of QT to $25 billion, more than half of the current level, reflects a strategic adjustment in response to potential risks and market conditions.
