We have been focusing on interest rates. Now it’s worth paying attention to the central banks’ decisions on Quantitative Tightening (QT). The Federal Reserve’s decisions may cause a weakening of emerging market currencies, which is significant for the Polish złoty.
The market is hawkish again, although this mainly affects the foreign exchange market. In terms of the stock market, we do not see significant fears related to maintaining high interest rates for longer. The market is not yet considering the U.S. Presidential elections, and there are no particular fears about the escalation of military conflicts on the part of Russia.
A March rate cut by the Fed is practically ruled out. At the moment, it seems appropriate to carry out 2-3 interest rate cuts this year, but the market is still pricing in about 5 such cuts.
Investors have long defended their optimistic view that a cut could take place as early as March. Yet by the end of January, the probability of a cut was estimated at just above 50%; chances of it happening are rapidly decreasing.
Investors’ attention should not only be focused on interest rates, but also on so-called quantitative tightening.
“Since the previous financial crisis, the Fed has been conducting unconventional monetary policy actions, more commonly referred to as QE (Quantitative Easing), which involves the acquisition of bonds and other debt papers from the market while simultaneously injecting money into financial institutions,” says Michał Stajniak, XTB expert, in an interview with MarketNews24. “With QE, especially during the pandemic, the Federal Reserve’s balance sheet has swollen to a gigantic $9 trillion. The amount of liquidity in the market was very large, leading to a significant increase in inflation.”
The Fed has been cutting back on its heavily inflated balance sheet since June 2022, which is also one way of combating inflation. However, many members of the Fed suggested in December that discussions should begin on slowing down QT.
So far, the Fed has reduced its nearly $9 trillion balance sheet by $1.3 trillion over several months. Fed research from 2022 shows that a cutback on the balance sheet equivalent of about $2.5 trillion is akin to a 50 basis point increase in interest rates. Therefore, despite not raising interest rates since last summer, financial conditions in the market continue to tighten.
“There’s still plenty of room for further tightening, but with significant inflation curtailment and desire to avoid a recession, the Fed will not only consider cutting interest rates but also ceasing balance sheet reduction,” comments the XTB expert.
The Fed definitely does not want to repeat the 2019 situation, where a reduction in financial system liquidity was excessive and led to a huge surge in borrowing costs for institutions. However, what level of balance sheet reduction is appropriate for the market and inflation remains unknown.
What if the Fed overdoes it? Of course, the Fed has the capability to quickly add liquidity through open market operations. Still, a sudden surge in demand for dollars could occur. On the other hand, if the Fed decided to end QT sooner or at least communicate that discussions have commenced, the next meeting, even without any communication about interest rate cuts, could be perceived as bullish for the dollar.
The Fed cannot lead to a significant increase in demand for the dollar, as this would primarily result in a rapid sell-off of emerging market currencies, with regional currencies, including the Polish złoty, suffering greatly.
“The market is not yet playing out the U.S. presidential elections, but it is concerned about the situation in Taiwan and conflicts in the Middle East. The search for safe assets is a testament to these fears, which is why the price of gold remains above $2,000 per ounce. This is why the dollar remains strong, especially noticeable in the EURUSD pair,” explains M. Stajniak from XTB.
