Ready, Set, Hike…

kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
01/26/2022

The New Year is now in full swing as the Federal Reserve has officially weighed in on the direction of interest rates…they’re going up! Obviously, the lion’s share of investor attention focuses on the outlook for Fed Funds, but it is also important to include the Fed’s thoughts on how and when balance sheet normalization could come into play.

First up, rate hikes. Unless an unexpected turn of events occurs on the economic/inflation front, the voting members seemed to have confirmed the market’s expectation that lift off will be in March. Even though there was no dot plot this time around, the Fed also didn’t seem to push back on the newfound belief that four rate hikes could be forthcoming this year. In fact, instead of a presumed timetable for “gradual,” or “measured,” rate increases as we have seen mentioned in past rate hike cycles, Powell & Co. are guiding the markets toward the notion that each FOMC meeting will be live. In other words, a rate hike could occur at any future FOMC meeting.    

That brings us to the balance sheet, or let’s call it quantitative tightening, a.k.a QT. That’s right, just as the Fed’s large-scale asset purchases of Treasuries (UST) and mortgage-backed securities (MBS) is an easing tool of monetary policy (QE), QT should be viewed as just the opposite, a tightening tool of monetary policy. 

What exactly is QT? One thing it is not is tapering. Remember, tapering is still adding to the Fed’s balance sheet, but at a lesser pace, so think of it as ‘QE-lite’. In contrast, QT is when the policy makers actually reduce their holdings of UST and MBS to shrink their balance sheet. It can come in two forms: 1) actually selling these aforementioned holdings or 2) letting their UST/MBS positions mature and/or redeem without replacing them. With regard to option #2, the Fed can decide to let the maturities/redemptions occur in full or the policy makers could choose to let a portion ‘run-off’ and reinvest the remainder of what actually matured/redeemed.

The timing of the Fed’s QT program is what will set this early rate hike cycle apart from the prior episode. Indeed, the policymakers stated that they expect to begin reducing their balance sheet “after the process of increasing the target range for the federal funds rate has begun.” With March looking like the timing for lift-off now, QT could start any time after that. 

Conclusion

So, besides trying to determine when to raise rates throughout the course of this year, the FOMC will also be determining how and when to proceed with their balance sheet drawdown. Recently, there has been a lot of conjecture that the Fed could raise rates more than four times in 2022. However, I would advise to not lose sight of the power of the balance sheet option. A drawdown of their UST and MBS holdings should be viewed as akin to a quarter-point rate hike, and perhaps that’s how the Fed gets to five ‘rate hikes’ this year. 

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About the Contributor
kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.