In Test for Markets, Quantitative Tightening Goes Global for the First Time

Over the past two decades, central banks in developed economies have navigated through numerous challenges, and now they are embarking on a new phase: synchronized quantitative tightening (QT). For the first time, major central banks, including the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of England (BOE), and the Bank of Japan (BOJ), are collectively reducing their balance sheets. This process involves withdrawing the liquidity that these banks had injected into their economies during the pandemic by purchasing bonds.

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The BOJ’s recent decision to gradually reduce its bond holdings in the coming years means it has joined other top central banks in the effort to contract their balance sheets. Although the approach to QT varies across these institutions, the overarching goal is to reverse the massive bond-buying programs that were implemented to stabilize economies during the crisis. However, this synchronized effort introduces new risks, as global liquidity is drained from the markets.

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The Fed’s initial foray into QT in 2019 was not without challenges. Unexpected disruptions in money markets caught policymakers off guard, leading to a sudden shift in strategy. Fed Chair Jerome Powell has since acknowledged the lessons learned from that experience and has committed to halting QT if necessary to avoid similar issues. Nonetheless, as the global economy faces a simultaneous withdrawal of liquidity, the potential for complications remains high.

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Steven Barrow, a seasoned foreign-exchange and fixed-income strategist at Standard Bank, warns that while the Fed may have learned from past mistakes, other central banks have yet to be tested in this environment. The risk of encountering problems as liquidity is withdrawn is real, particularly as central banks have not faced such a coordinated QT effort before.

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On Wall Street, many anticipate that the Fed’s QT program may be nearing its end. With the U.S. economy showing signs of slowing, there is speculation that the Fed will soon shift to cutting interest rates to provide support. The Fed has already slowed the pace of its balance-sheet reduction, and recent minutes from a policy meeting reveal that several officials emphasized the importance of monitoring money market conditions as QT continues.

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This cautious approach is reinforced by recent signs of stress in funding markets, leading some to expect the Fed to conclude its QT program soon. Barrow notes that the recent selloff in global stocks, which peaked in early August with the steepest decline since 2020, could be a warning sign of potential QT-related market disturbances.

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In the U.S., the 2019 episode of funding shortages in the repurchase agreement market serves as a case study. That experience gives confidence to some observers that central banks, particularly the Fed, will be able to adjust their policies as needed to maintain financial stability. The BOE’s recent experience provides another example. In 2022, the BOE delayed the start of its bond sales due to turmoil in the UK bond market triggered by fiscal policies from former Prime Minister Liz Truss. This volatility forced the BOE to temporarily buy gilts under its financial-stability mandate. However, once the market settled, the BOE resumed its QT program, demonstrating that central banks can adapt their strategies to minimize market impact.

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Sayuri Shirai, a former BOJ board member, highlights that while all central banks that previously engaged in quantitative easing (QE) are now undertaking QT, they are also beginning to lower interest rates. This could help offset any downward pressure on bond prices caused by QT. Shirai also notes that central banks have shown a willingness to halt or adjust their QT programs if market conditions warrant, as seen during the UK’s 2022 mini-budget crisis.

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Central banks are at different stages of QT. The Fed is expected to wind down its program soon, while the BOJ is just starting its initiative. Despite the large reserves held by banks at the Fed, estimated at around $3.3 trillion, some market participants are concerned about potential cracks similar to those seen in 2019, which could necessitate an early end to QT. The Fed now has additional liquidity backstops that were not available in 2019, providing some reassurance against sudden funding pressures.

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In Europe, the ECB has stopped reinvesting some maturing bonds, though it still maintains a structural portfolio to provide liquidity to the financial system. The Bank of Canada (BOC) has been reducing its balance sheet for over two years, but this has sometimes strained short-term funding markets, leading to periodic interventions. Despite these challenges, the BOC plans to continue with QT until its balance sheet is “normalized.”

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The BOE has taken the most aggressive approach, actively selling bonds rather than merely reducing reinvestments. To address any market liquidity issues, the BOE encourages banks to use various lending facilities for cash as needed. Meanwhile, the BOJ is new to QT, with plans to reduce its bond holdings by 7% to 8% over the next two years. As QT continues, the risk of market volatility looms, with some observers suggesting that the recent fluctuations in the yen and global equities signal the return of volatility.

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As governments face mounting public debt, there is concern that they may pressure central banks to slow QT to support bond markets. Stephen Jen, CEO of Eurizon SLJ Capital, notes that the challenge for central banks will be executing QT in the face of large debt issuances, which could exacerbate market volatility if left unchecked.

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