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How Quantitative Tightening is Supposed to Work
A short primer on the calculations
There’s been a lot speculation around the Fed’s plans for balance sheet reduction, or what we fondly like to call Quantitative Tightening (QT). Much of the speculation is around whether the Fed is actually running off the balance sheet or not because at first glance it seems like the balance sheet there’s no reduction. That, of course, is not true. The Fed really is tightening.
So I thought I’d try to explain how the Fed is supposed to be conducting QT and what’s happened so far.
Just to be clear, all of this information is publicly available and I’m just trying to distill the information to bring you the essence of it.
I wrote a piece in early May where I’d discussed what happened the last time around that the Fed decided to hike rates and implement QT. It did not end well and the Fed had to drastically reverse course. Here’s a link to the free article and it’s really worth reading for a recap.
The QT Plan
This time around the Fed did a two stage plan for QT. They discussed a 3-month easing in period starting June 2022, when the balance sheet run off would be capped at $47.50B per month - Treasuries at $30B and Mortgaged-backed securities (MBS) at $17.5B. It’s important to remember that these were just the upper limits, i.e, they didn’t have to reach these amounts and we will see why in just a minute.
Looking at a quick review of the balance sheet, though we see that the Fed didn’t actually let MBS run off and the total amount reduced has been ~$17.23B per month, on average.
Now, the Fed’s cap is doubling to $95B per month - Treasuries at $60B and MBS at $35B - starting 01 Sep 2022.
There are three kinds of securities that will be involved in QT:
Agency Mortgage Backed Securities (MBS)
Coupon bearing Treasury Securities (Treasuries)
Treasury Bills (T-Bills)
We know that the Fed had been accumulating these securities through the System Open Market Operations or SOMA. What they do is ask the Desk Operations (“Desk”) of say, the NY Fed to place non-competitive bids at auctions to buy securities that are left over. Upon maturity of these securities, the Desk would be rolling over or reinvesting the principal payments for these holdings. This is what has happened for the better part of the last three years.
How the Cap Works
For the purpose of this exercise, the securities are divided into two MBS & Treasuries + T-Bills.
The basic concept of the cap is the same when applied to both.
They look at the total amount of maturities in a month and whatever amount exceeds the cap, will be reinvested or rolled over.
So how does the calculation work?
Cap = $35B.
Total maturity amount in a month = $40B, for example
Total Reinvestment = $40B-$35B = $5B
For Treasuries & T-Bills
Cap = $60B.
Total maturity amount in a month = $75B, for example
Total Rollover = $75B-$60B = $15B
At any point, if the total amount of maturing securities is lower than the cap, then no principal payments get reinvested or rolled over.
Simple enough, so far.
How does this get implemented in terms of the distribution during the the month? It’s done proportionately. The securities are reinvested or rolled over twice a month. Each maturity amount is taken as a proportion of the total months maturity and this fraction is applied to the redemption and the rollover amounts. This is shown below:
An interesting twist to the Treasury portions of the QT is the T-Bills.
The T-Bills are lumped in with the Treasury Securities, as I mentioned above. So, let’s look at the calculation breakdown here:
Cap = $60B
Total Treasury Coupon Maturity = $40B
Total T-Bill Maturity = $50B
Total Rollover = $90B - $60B = $30B in T-Bills
of which the total Treasury Coupon of $40B will be redeemed and $ $20B of the T-Bills will be redeemed, so the T-Bills of $ 30B remain and will be rolled over. Again, this will be spread over the 4-week maturity schedules in proportion to their maturing amounts.
I found this great graph on Bloomberg which shows what the schedule looks like between the Treasury Coupons and the T-Bills. From what it seems, the Fed has less coupons coming due in most of the coming months and a significant amount of T-Bills will also get redeemed.
Now, that we know how the calculation works, it’s pretty easy to see why there may be some misunderstanding around this.
In any given month, if the maturities are below the cap, everything gets redeemed.
In any given month, if the maturities are above the cap, the rest gets rolled over.
So, if the maturities are far above the cap, then the proportion that’s getting rolled over is much higher. For example, the MBS cap is $35B but the maturity amount for that month say, is $80B. Then a whopping $45B gets reinvested, i.e., even higher than the redemption amount.
I hope this was an easy, helpful breakdown.