What about QT?

Week of January 21, 2025

All of the attention when it comes to future Fed monetary policy decisions has been laser-focused on rate cuts. We would have to concur, and rightfully so. However, that doesn’t mean investors should take their eyes off the ball and not consider the Fed’s balance sheet.

Even though the Fed has already cut rates by 100 bps, quantitative tightening, or QT, remains an active part of monetary policy as well. Think about that statement for a minute. The Fed is becoming less restrictive with respect to the Fed Funds trading range, BUT it is also reducing its balance sheet at the same time. Interestingly, the Fed would argue there is no divergence at all. The natural question is: how long can this seemingly divergent policy path last?

Let’s first take a quick look at where the rate aspect may be headed. Chairman Powell has emphasized how the policy maker would like to get monetary policy, i.e., rates, to a neutral stance. What neutral actually means based on Fed Funds is also a good question. As of the December Summary of Economic Projections, the Fed had raised the level to 3.0%, but we feel a more realistic reading starts at 3.50%, if not higher. The bottom line is that the neutral rate will more than likely be a moving target for the policy maker as 2025 unfolds, and despite recent comments from Fed Governor Waller, the voting members do not appear to be in a hurry to get to neutral, at least at this stage of the game.

So that brings us to the balance sheet, or more specifically, the Fed’s holdings of Treasuries, Federal agency and mortgage-backed securities (MBS), otherwise known as the System Open Market Account, or SOMA. While QT is still ongoing, the reader may recall the Fed actually pared back the pace of reduction in June of last year.

For those keeping track, the current pace of QT stands at $25 billion per month for Treasuries and $35 billion per month for agencies and MBS. Interestingly, when the Fed made the announcement to slow the pace of QT last year, all of the reduction came in the Treasury component as the agency and MBS aspect remained at its original pace. This was done by design, as the policy maker’s goal is to, at some point, get SOMA to be in a position where it is only holding Treasuries and nothing else essentially.

As of this writing, securities held outright by the Fed stood at $6.5 trillion, or about $2 trillion below the level that existed before QT was started in 2022. In terms of the breakdown, Treasuries have been reduced by about $1.5 trillion, with MBS being pared back by $0.5 trillion. Federal agency holdings are unchanged and stand at a relatively small amount.

Looking ahead, while the debate surrounding when the next rate cut may be coming will loom large, the Fed will more than likely also be signaling its intentions surrounding its balance sheet. A reasonable case scenario revolves around the policy maker ending QT altogether later this year, with the only question being a matter of when, not if.