Why the market is convulsing over quantitative tightening

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The Federal Reserve is balancing rate hikes with reduced bond purchases in a race to tighten. The mix it decides on will have major ramifications for sharemarket investors.

I’m not a dove, Lael Brainard shocked the market with some hawkish comments.Her comments – about a process we’ve come to know as quantitative tightening or QT – were the catalyst for a sharp sell-off in the bond market. As long-term yields shot higher,Those violent moves reflect a degree of surprise that the pace of balance sheet reduction could change.

This is because their core line of business – which is borrowing money for a short term and lending it for the long term – is more profitable the higher long-term rates are, relative to short-term rates. The steeper the yield curve, the more banks will lend. This potentially unhelpful phenomenon suggests that the Fed might be better off doing more in the way of quantitative tightening than rate hikes.QT would increase mortgage rates in absolute terms and slow consumption to counter inflation. But it would also maintain steepness in the yield curve, and therefore secure the flow of credit into the economy, facilitating capital investment.

 

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