QT Will Be The First Casualty In The Great Tightening

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by Tyler Durden
Wednesday, Jun 15, 2022 - 05:40 PM

By Simon White, Bloomberg Markets Live commentator and reporter

Wider credit spreads are likely to prompt central banks to ease up on QT sooner than expected, with the hope that interest rates will do most of the heavy lifting in reducing inflation.

The perils of tightening liquidity in a highly indebted world are becoming startlingly clear (again). Risk assets are getting clobbered, but even more worrisome for central banks is the widening of credit spreads.

The reason is the sharp fall in excess liquidity. It is excess liquidity -- liquidity created above and beyond the needs of the real economy -- that keeps assets supported. When it is in decline as it is currently, assets no longer have a safety net, leading to risk aversion and spread widening.

Balance-sheet reduction from the Fed, the ECB et al will contract liquidity yet more. But just as rising liquidity floats all boats, falling liquidity can simultaneously sink them all. Every dollar of the monetary base supports $10 of credit, but every $1 destroyed in QT takes $10 of credit with it.

QT therefore stands to be the first casualty in the move to tighter monetary policy in the US, Europe and elsewhere. Indeed, Europe took a step towards this with its announcement today that it would be flexible in using PEPP redemptions to support bonds. This is potentially an early shift towards dropping sequencing altogether, allowing the ECB to raise rates while the balance sheet is neutral or expanding.

The Fed, like the ECB, also finds itself in an impossible position. Growth in the US is easing at an increasing rate, meaning a recession could be on the cards in the not too distant future. The Fed will very likely have to pause or even reverse course much sooner than it or the market currently anticipates -- although that is not the story for today’s FOMC, with a 75-bp hike baked in.

Nevertheless, watch US high yield and junk credit spreads carefully -- especially in the days after the FOMC’s announcement -- as they could yet push the Fed in a direction the ECB is already heading in. Credit spreads are the most direct link between the real economy and markets, and when credit blows out it triggers the self-reinforcing feedback loops between asset prices and the health of the economy that lead to the regime change of a recession.

Credit spreads across the board in the US have been widening with increasing speed, with high-yield spreads close to doubling this year. Leading indicators show that spreads are set to get even wider.

Credit will come under increasing pressure, and could force the Fed to take action, just as occurred in 2020 when it announced its corporate credit facility. Easing up on QT would be an obvious option to support excess liquidity, while rising interest rates (hopefully) continue to restrain consumer inflation.