A Subtle But Critical Fed Policy Change All Investors Should Know

A subtle, but critical Fed policy change ….  

If you missed Dominos is Rolling Again here is the LINK.  

In 2020, the Fed executed its stimulative policy using dual tracks.  1 ) reduced rates close to zero, 2) initiated a quantitative easing program by buying $100 billion per month of mortgages and long duration treasuries.  

The result of this policy was record low short term rates and record tight spread between 30 year mortgage rates and the 30 year Treasury bonds. 

In late 2020, once it was clear that another big fiscal stimulus was coming, Fed should have at least stopped QE.  However, at the time, changing QE was deemed to be a confusing message for the market.  The Fed continued QE into early 2022.

It was a big mistake.  

Over the past year, the Fed was executing its tightening policy again via dual tracks.  1) Raising rates to get the Fed Funds Rate (FFR) above inflation and 2) Reducing its balance sheet easing by letting maturing bonds roll off.  

The result was not only rising rates across the rates complex but also wider spreads between 30 year mortgage rates and the 30 year Treasury bonds. 

Mortgage rates sky rocketed.

Today, the FFR is significantly above all market based inflation measures.  It’s again time to change policy.

However, the Fed has learned from its mistakes from 2020.

The Fed is guiding to 3 rate cuts in 2024.  However they have deemed Quantitative Tightening (QT) an independent and separate policy.  

QT will continue, even in a rate cutting cycle.

How long will QT go on?

QT will continue until the reverse repo facility (excess cash in the system) gets down to a comfortable level of reserves.  The target is the minimum amount of cash needed for the financial system to properly function.  In 2019, the reverse repo facility showed significant stress below $3 trillion dollars.  Today, we are far above that at $4 trillion. At $80-90 billion per month, QT is likely to continue for another 6-9 months.

Get ready for a new Fed that is cutting rates and shrinking its balance sheet, at the same time.

Thanks for reading!