The Federal Reserve’s program to reduce its balance sheet, known as quantitative tightening (QT), is expected to end in December of this year without significantly disrupting financial markets, according to specialists at Barclays (LON:).
These experts contrast the current gradual approach with the abrupt cessation of QT in 2019, which caused unexpected funding difficulties. Barclays’ analysis highlights the strategies the Federal Reserve has adopted to avoid repeating past mistakes and facilitate a smooth transition.
“The Fed overextended the QT process in 2019,” Barclays noted. “The Fed lacked a precise understanding of the levels of additional funds that banks wanted to hold for safety, and paid too much attention to the specific area of the federal funds market.”
In the current situation, the Federal Reserve is proceeding with greater caution. It has expanded its monitoring of the conditions under which financial institutions lend to each other and has begun to reduce QT while banks continue to have access to more than $3.4 trillion in reserve funds. In addition, the establishment of a central counterparty for operations and the Standing Repo Facility (SRF) act as additional protections against a sudden lack of financing similar to what occurred in 2019.
Several indicators that previously pointed to market tensions in 2018-19 are now showing elevated activity. Hedge funds hold a similar amount of US government bonds financed by collateralized loans, and the inventory of US government bonds held by financial firms is at an all-time high.
However, Barclays believes that the Federal Reserve’s preparedness and preventative measures will ensure a non-disruptive conclusion to the QT.
“We identify two main reasons to anticipate a more orderly conclusion to QT this year,” the analysts noted.
“First, the Federal Reserve appears to be more attentive to financial markets and conditions beyond the narrow scope of the federal funds market,” the analysts say.
The second reason for Barclays’ optimism is the growth in transactions where a third party facilitates the operation and central clearing since 2020. These practices have effectively increased the ability of financial firms to manage their inventories through clearing.
“Third-party facilitated transactions – and central clearing more broadly – increase the ability of financial firms to manage their inventories through clearing. The volume of such transactions, both buy and sell, exceeds $1 trillion and has more than doubled since 2019,” the report said.
In conclusion, Barclays anticipates that the Federal Reserve will end QT in December “without major disruptions” and “before indicators of stress appear in the federal funds or repo markets.”
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