Fed Money Printer Goes Into Reverse (Quantitative Tightening): What Does It Mean For Crypto?

We discuss what to expect as the Fed. massively drains liquidity from the market – the opposite effect of QE. Fed Money Printer Goes Into Reverse (Quantitative Tightening): What Does It Mean For Crypto?

Also, we cover what will happen to the crypto markets when quantitative tightening takes full effect and the Federal Reserve shelves the money printer.

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The United States Federal Reserve is starting the process of paring back its $9 trillion balance sheet that ballooned in recent years in a move called quantitative tightening (QT).

Analysts from a crypto exchange and financial investment firm have conflicting opinions about whether QT, starting on Wednesday, will put an end to a decade of unprecedented growth across crypto markets.

The worst part about this is that I would imagine ~80% of Americans have no idea what QUANTITIVE TIGHTENING is

Why would we, this wasn’t taught in public school

The SEC should worry about educating Americans on these terms as I believe that’s part of “PROTECTING” us https://t.co/Z8RwUNPJwF

— WendyO.eth ✨ (@CryptoWendyO) May 31, 2022

Laypeople can consider QT the opposite of quantitative easing (QE), or money printing, which the Fed has been engaged in since the start of the COVID-19 pandemic in 2020. Under QE conditions, more money is created and distributed while the Fed adds bonds and other treasury instruments to its balance sheet.

The Fed plans on shrinking its balance sheet by $47.5 billion per month for the next three months. In September of this year, it plans on a $95 billion reduction. It aims to see its balance sheet reduced by $7.6 trillion by the end of 2023.

Bitcoin has never once in its history been in a bull market while the Federal Reserve did quantitative tightening.

Smart whales spent the last 12+ months dumping their bags on dumb retail.

The mega crash is inevitable!

— CryptoWhale (@CryptoWhale) May 4, 2022

Pav Hundal, manager at the Australian crypto exchange Swyftx, believes that QT could have a negative impact on markets. He told Cointelegraph on Wednesday that “it’s very possible that you might just see growth in market cap trimmed slightly:”

“The Fed is culling assets harder and faster than a lot of analysts had expected and it’s difficult to imagine that this won’t have some kind of impact on investor sentiment across markets.”

Initiated in March 2020, the impact of QE on the crypto market was dramatic. CoinGecko data shows that the crypto market cap languished through 2019 and early 2020, but a vibrant bull market began in late March 2020 as the money printer fired up.

The total crypto market cap burst from $162 billion on March 23, 2020, to a peak of just over $3 trillion last November.

Over a similar time frame, the Fed balance sheet increased 2.1 fold from $4.17 trillion on January 1, 2020, to $8.95 trillion on June 1, 2022. That is the fastest rate of increase since the last global financial crisis starting in 2007.

Financial advisory firm deVere Group CEO Nigel Green believes market reactions to QT will be minimal because “it’s already priced in.” Green said there may be a “knee-jerk reaction from the markets” because of the unexpected speed with which QT is being rolled out, but he sees it as a little more than a wobble:

“Furthermore, we expect a market bounce imminently, meaning investors should be positioning portfolios to capitalise on this.”

Wage increases among American workers, especially in the hospitality industry, have already been observed as labor demand remains high. Assuming wages remain high through QT, the U.S. may emerge from the economic downturn with lower income inequality.

Crypto market analyst Economiser explained in a Tuesday tweet that if people wind up with more cash in their pockets from their higher wages, “the crypto market could ultimately benefit” from QT.

Wage equality:

Interestingly, the highest wage growth is in the hospitality & retail sectors.

This could mean that the US comes out of this economic downturn with ↓ income inequality.

And if more people have disposable income, the crypto market could ultimately benefit. pic.twitter.com/J3DQ2DwnDZ

— Economiser (@economiserly) May 30, 2022

Hundal added that while markets are experiencing increased volatility lately, Bitcoin (BTC) could benefit as it is now demonstrating its position as a bellwether asset. He noted that Bitcoin dominance is currently at about 47%, up by eight percentage points from the start of 2022. He said, “There are different ways to interpret this,” adding:

“It does suggest that market participants are seeking to park value in Bitcoin, meaning we could see weakness continue to trend across alt coin markets if current market conditions continue to play out.”

Fed Starts Experiment of Letting $8.9 Trillion Portfolio Shrink

* First Assets Will Mature Without Reinvestment On June 15
* Officials Uncertain About Market Impact Of Accelerated Runoff

The Federal Reserve is about to start shrinking its $8.9 trillion balance sheet, deploying a second tool along side higher interest rates to curb inflation, though officials don’t know just how effective it will be.

After doubling in size through asset purchases in the first two years of the pandemic, the balance sheet will be reduced at a pace that’s almost twice as fast as after the last financial crisis.

While the process officially commences on Wednesday, the first US Treasury securities won’t run off until $15 billion mature on June 15.

Fed’s June Maturities

Fed Money Printer Goes Into Reverse (Quantitative Tightening): What Does It Mean For Crypto?

Four Treasury securities held by the Fed are maturing in June, totaling $48.25 billion, leaving $18.25 billion over the $30 billion runoff cap to be reinvested

The Fed is capping monthly runoff at $47.5 billion — $30 billion for Treasuries and $17.5 billion for mortgage-backed securities — until September. Those thresholds will then double to a combined $95 billion. That compares to a peak of $50 billion a month when the Fed performed the exercise starting in 2017.

Officials say the reduction will work in tandem with interest-rate increases to cool price pressures by tightening financial conditions. But it’s not clear how much impact the balance sheet will have.

As Fed Governor Christopher Waller put it in a speech on Monday, estimates “using a variety of models and assumptions” are “highly uncertain.”

The Fed deployed massive asset purchases during the 2008 financial crisis for the first time since World War II, expanding the balance sheet to about $4.5 trillion by the time it stopped buying at the end of 2014. It then waited three years before allowing it to begin shrinking at the end of 2017, reducing it to about $3.8 trillion by September 2019.

Uncertainty over the course of the balance sheet was said by commentators to have contributed to the market turmoil that ultimately helped bring an end to the Fed’s last rate-hike campaign, which concluded in December 2018.

Now, the Fed is also raising its benchmark rate at a faster pace in a bid to tighten financial conditions and tame inflation, which in recent months has reached the highest levels in four decades.

Minutes of the Fed’s most recent policy meeting, on May 3-4, said that, “Regarding risks related to the balance-sheet reduction, several participants noted the potential for unanticipated effects on financial market conditions.” The next meeting is scheduled for June 14-15.

Updated: 6-2-2022

Federal Reserve’s Portfolio Runoff Has Begun

Central bank is allowing securities to exit from its $8.9 trillion portfolio by not reinvesting the proceeds when they mature.

The Federal Reserve began the process Wednesday of shrinking its $8.9 trillion asset portfolio. Here are answers to five of the most commonly asked questions from our readers about how it works.

Q: When The Fed Shrinks Its Asset Portfolio, Is It Selling Bonds?

No. The Fed dramatically expanded its portfolio in March 2020 to stabilize dysfunctional markets, and then it continued to purchase Treasury and mortgage-backed securities in large quantities after that to provide additional stimulus to the economy by holding down longer-term yields. It ended those purchases in March 2022 and has been keeping its holdings steady since then by reinvesting the proceeds of maturing securities into new ones.

Starting June 1, the Fed will allow up to $30 billion in Treasurys and $17.5 billion in mortgage bonds to mature every month without investing the proceeds. The central bank is shrinking its holdings passively, or by attrition. (Because none of the Fed’s Treasury holdings mature until June 15, this process for Treasurys doesn’t actually take effect for two more weeks). In September, the Fed will allow twice as many securities—$60 billion in Treasurys and $35 billion in mortgage bonds—to run off its portfolio.

This design is similar to how the Fed allowed its holdings to shrink between October 2017 and July 2019, though the amounts of securities that are running off the Fed’s holdings are larger now than they were then.

Q: But What About Mortgage Securities? Some Fed Officials Have Said Those Could Be Actively Sold At Some Point. Why Is This Under Consideration?

The Fed has said that over the long run, it wants to own primarily Treasury securities. Selling mortgage assets would more quickly shift the composition of its asset holdings toward Treasurys.

The Fed didn’t actively sell mortgage bonds last decade, but it never ruled out such sales. And it hasn’t ruled out sales of its $2.7 trillion in mortgage-backed securities at some point down the road this decade, because it will take a long time to shrink those holdings passively.

The 30-year mortgage rate has increased by more than 2 percentage points over the past six months, which will lead to much lower refinancing volumes and therefore fewer early paydowns of such long-term securities in the coming years.

The upshot is that even though the Fed will allow up to $35 billion in mortgages to run off its portfolio by September, in most months, the Fed might see less than $20 billion in securities decline through passive runoff.

Officials haven’t decided whether or when to sell securities, and minutes from the Fed’s recent policy meetings haven’t provided many clues about the debate inside the central bank’s rate-setting committee.

Because mortgage rates have increased substantially, officials will have to weigh the economic effects of any such sales. At current interest rates, the Fed is also likely to sell those assets at a loss.

Q: What Does The Fed Do With The Money It Receives From The Payment Of Principal On Its Holdings?

The Fed essentially created money out of thin air to buy the bonds. Now, it will destroy the money in the same way.

When private investors buy bonds, they use cash, borrow funds or sell assets to raise the money to make that purchase. The Fed is different.

It doesn’t have to do any of those things because it can electronically credit money to the accounts of bond dealers who sell mortgage-backed securities or Treasurys.

When the Fed purchases a security, it creates a bank deposit known as a reserve that shows up in the account of the seller.

When the process is reversed, instead of reinvesting the proceeds of maturing bonds, the Fed erases them electronically.

It doesn’t print currency to purchase the bonds, and so it won’t be destroying any paper currency. The electronic money essentially vanishes from the financial system.

The New York Fed provides a detailed breakdown of the accounting on its Liberty Street Economics blog.

Q: What Effect Does This Have On The Economy?

There is no consensus on the effects of the Fed’s asset purchases, sometimes called quantitative easing, and the portfolio runoff, sometimes called quantitative tightening. Several analysts have suggested that the runoff could be equivalent to one or two quarter-percentage point increases in its benchmark short-term interest rate.

In theory, the Fed’s purchases should reduce long-term yields by pushing down the so-called term premium, or the extra yield that investors receive for holding longer-dated assets.

Analysts at JPMorgan Chase & Co. have estimated that each $1 trillion in Fed bond purchases during and after the 2008 financial crisis reduced the term premium on a 10-year Treasury note by 0.15 to 0.2 percentage point.

Runoff should boost the term premium by increasing the supply of bonds that private investors must now absorb, pushing their prices down and raising bond yields, which move in an inverse relationship to prices.

Treasury debt issuance decisions also matter. In late 2018, some investors grew concerned about the effects of the Fed’s portfolio runoff, but back then, the amount of debt being issued by the Treasury was increasing sharply as tax revenues declined following tax cuts approved by then-President Donald Trump.

Right now, tax revenues are surging, which could require the Treasury to issue less debt than would otherwise be the case.

Q: When Will The Fed Stop Its Portfolio Runoff?

The end date isn’t clear. In 2019, the Fed slowed its runoff program much sooner than most officials had initially anticipated, and halted the runoff in July 2019, when the Fed cut interest rates amid concerns over an economic slowdown.

In September 2019, turmoil in overnight lending markets led officials to conclude that they had drained too many reserves from the financial system, leading them to make a U-turn and increase the portfolio for several months. That fine-tuning was mooted by the aggressive response to the Covid-19 pandemic in March 2020.

In a February speech, Fed governor Christopher Waller said he thought reserves as a share of gross domestic product—around $3.8 trillion or 16% of GDP at the end of March—could potentially decline to levels seen in early 2019, when they were around 8% of GDP.

Projections released last month by the New York Fed suggested that this might be consistent with allowing Treasury and mortgage holdings to decline to around $6 trillion in mid-2025.

The economy’s performance will also shape the endgame. The Fed could halt the runoff sooner if, for example, officials switch from raising rates to cutting rates in the next few years.

Updated: 6-7-2022

Morgan Stanley Sees Crypto Equivalent of Quantitative Tightening

“Only when the tide goes out do you discover who’s been swimming naked.” Warren Buffett

The bank pointed to weakness in crypto markets, the failure of a dollar stablecoin and a reduction in leverage in decentralized finance.

Weakness in crypto markets, the failure of a dollar stablecoin and a reduction in leverage in decentralized finance (DeFi) are resulting in the “crypto equivalent of quantitative tightening,” Morgan Stanley (MS) said in a report Tuesday.

The recent collapse of stablecoin TerraUSD (UST) saw Tether (USDT) also lose its dollar peg intraday, and this caused crypto prices to drop further as some questioned the stability of the third-largest cryptocurrency, bank said.

USDT has a market cap of $73 billion and is the most heavily traded digital asset on a daily basis, the report said. More than half of all bitcoins (BTC) traded on exchanges are traded against USDT.

Investors are redeeming USDT at a record pace, the bank said. Some $10.6 billion of redemptions occurred in the last month alone, while other stablecoin issuance is not rising.

Morgan Stanley called this the “crypto equivalent of quantitative tightening, as total stablecoin market cap falls, and liquidity on decentralized exchanges and leverage on lending platforms falls even faster.”

Of the $10 billion of USDT redeemed, $5.9 billion was on the TRON blockchain, with much less on Ethereum, the note said. At $21 billion, crypto exchange Binance is the largest known owner of USDT and controls 49% of the stablecoin issued on TRON, the note added.

According to the report, Binance, FTX and Bitfinex were the three largest redeemers of USDT. Curve, a DeFi exchange, hosts over a third of USDT on DeFi platforms, and here traders were swapping USDT for other stablecoins, it added.

“Systemic spillover” risks from the crypto markets to the fiat banking system appear limited, the bank said, because the leveraged crypto companies usually borrow from each other. However, if USDT falls materially under its $1 peg, this would have a larger negative impact on crypto and risk markets.

Updated: 6-16-2022

Fed To Lose Money Next Year As It Raises Rates, Dudley Says

Unable To Sell Mortgage-Backed Securities

It’s also held out the possibility of selling some of its mortgage-backed securities as part of its plan to slim its balance sheet.

“If they’re losing money they’re not going to be selling agency MBS,” Dudley said. “Every one they sell is going to add to their losses.”

* Fed Will Be Paying More To Banks Than It Earns On Securities

* Loss To Dissuade Fed From Mortgage-Backed Bond Sales, He Says

The Federal Reserve looks on course to lose money next year as it raises short-term interest rates to try to rein in inflation, according to former New York Fed President William Dudley.

That’s because the interest rate the Fed will be paying out to banks for the reserves they hold at the central bank will be greater than the rate it earns on its huge holdings of Treasury and mortgage-backed securities.

While the losses won’t impact the Fed’s ability to conduct monetary policy, they will dissuade policy makers from selling mortgage-backed securities because that would add to the red ink, Dudley told a webinar on Thursday sponsored by Official Monetary and Financial Institutions Forum.

Fed Chairman Jerome Powell and his colleagues raised rates on Wednesday by 75 basis points — the biggest hike since 1994 – and penciled in further increases for the balance of this year and into next. They now see rates rising to 3.4% at the end of this year and 3.8% at the end of 2023, according to their median projection, from a current target of 1.5% to 1.75%.

“If we stay on this trajectory, the Fed is definitely going to lose money in calendar year 2023,” Dudley, who is an adviser to Bloomberg Economics, said.

In that event, the Treasury would create a so-called deferred asset on the Fed’s balance sheet so that the central bank would not have to deplete its capital, he said. “Monetary policy implementation won’t be affected” as a result.

Besides raising interest rates to quell inflation, the Fed is also reducing its mammoth balance sheet by not replacing the securities it holds when they mature.

He expects the Fed losses to trigger a “fierce debate” about the Fed’s past use of quantitative easing to aid the economy. Opponents of QE could seize on the losses to argue that the Fed shouldn’t be in the business of buying longer-dated securities.

It would be a disaster if they win the debate, according to Dudley. “If that were to happen that’s really dangerous because you’re taking away a very important tool of monetary policy when the Fed is at the zero lower bound” of short-term interest rates, he said.

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