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Plus and minus: can QT annihilate QE (and other anti-inflation questions for financial markets)

Fiorino queries whether investors should expect an equal-and-opposite reaction as central banks release the anti-QE solution into the real world...

Anti-matter emerged as a theoretical concept from the Nobel Prize-winning doodlings of wunderkind UK physicist, Paul Dirac, in 1928 as he attempted to pin down the behaviour of close-to-lightspeed electrons with mathematical precision.

The Dirac equation, however, implied both a negative and positive solution for the electron charge – just as x²=4 can be solved by replacing the unknown quantity with 2 or -2.

Dirac initially dismissed the positive electron outcome as a quirk of maths rather than a physical reality before jumping to a stunning conclusion that the result strongly suggested that for every particle there exists an actual corresponding antiparticle (see Figure 1 below).

Figure 1: The asymmetry of matter and anti-matter


Only four years after Dirac tabled his famous equation, US physicist, Carl Anderson, observed an anti-electron (now known as a positron) for the first time, sparking an anti-matter research effort that has since enabled scientists to study and even create real anti-particles while speculating on the existence of a range of anti-entities including even an anti-universe.

But opposites don’t attract in matter/anti-matter interactions; they annihilate in a blast of pure energy.

Figure 2:  The anti-electron – or positron – compared to an electron  


Anti-QE: central banks add in negative inflation solution

After spending more than a decade expanding the financial universe with ever-larger infusions of quantitative easing (QE), monetary policy-makers are now scrambling to reverse the experiment amid rampant inflation.

And as part of the inflation-fighting mission, central banks will introduce quantitative tightening (QT) into the mix. Given the extraordinary amount of liquidity in the system, the monetary masters run the danger of an explosive market reaction if QE meets its anti-particle of QT en masse.

Venturing into such unknown territory, monetary authorities have to date taken an understandably cautious approach on QT with two of the most important entities – the US Federal Reserve and the European Central Bank (ECB) – plotting different paths to ‘normalisation’.

The ECB, for example, lags well behind the Fed in the pace of interest rate hikes – although both are indicating more rises lie ahead. Investors will also have to parse the impact of QT as the two central banks diverge on how they dispose of the huge piles of various fixed income instruments accumulated during a decade-long QE splurge.

In the aftermath of the 2008 global financial crisis (GFC), both the Fed and ECB brought vast quantities of goverment bonds, corporate mortgage-backed securities (MBS), agency paper and other securities onto their respective balance sheets. While the Fed has laid out a plan for reducing the QE stockpile, the ECB strategy is less clear. The European central bank faces a big constraint for both QE and QT due to the capital key calculation, which determines how much money member states must contribute to fund the ECB.

FED-style QT: converting reserves into loanable funds

Under its QE programme the Fed buys fixed income instruments from banks, which hold the assets already or purchase them at auction on behalf of the central bank. By law, the Fed cannot buy government securities directly from the US Treasury, hence the use of intermediary banks.

The Fed pays for such QE purchases by crediting the intermediary banks with a reserve held at the central bank. If the intermediary bank already holds the securities in question, the transaction is recorded as an asset swap.

Meanwhile, the US Treasury will either spend the cash raised via the QE securities-selling process – creating deposits in the financial system – or keep the money at the Fed.

By paying an interest rate set at or above the official funds rate, the Fed keeps reserves captive.

Importantly, from a commercial bank’s treasury function point-of-view, the Fed QE programme must keep the yields of all other short-term assets that meet the high-quality liquid assets standard below the official funds rate.

However, when the Fed starts shrinking its balance sheet via QT it will own fewer treasuries (and other securities such as MBS), reserves will drop and banks can use this money for lending or investment purposes.

Following the GFC, households and businesses in most developed countries have been deleveraging, taking bank loan-to-deposit ratios well below 100%. (The introduction of Basel III liquidity ratios has also hampered loan growth.)

At present, banks have incentives to return loan-to-deposit ratios to pre-GFC levels and recent lending growth in the US indicates financial institutions are doing just that in a process that could reverse a decades-long trend.

Reserves at banks are growing relative to deposits while loans (households and business) and treasury holdings are shrinking compared to deposits. Furthermore, since the 1950s US banks have been lowering their holdings of government bonds as a share of the total marketable treasury debt.

Figure 3: US treasuries ownership

Source: US Federal Reserve

As the chart above reveals, while domestic banks have reduced their proportionate exposure to US Treasuries, foreign investors – notably, China, Japan, Korea and other global central banks – extended their ownership of the assets from insignificant levels in the 1960s to become key market players today.

The Fed QE program essentially took cash from banks to invest in markets, crowding out domestic and foreign investors. Finally, asset price inflation erupted as capital markets recycled the QE-generated cash.

Shaken into action by stubbornly high inflation data, the Fed officially ended QE purchases this February and slated a June 1 start date for QT, beginning the mammoth task of reducing its $9tn balance sheet.

According to a Fed statement, the central bank will halt QT when the banking system reserve balances are “somewhat above the level it judges to be consistent with ample reserves”.

Euro-eccentric: ECB stays loosely behind the curve

Over in the eurozone, the ECB appears to have – on the surface, at least – a much more direct path to QT: reducing the bond exposure on its balance sheet will see fewer commercial bank deposits held by the ECB.

But it’s doubtful that a European QT program will follow the simple equation of subtracting €1 in bonds from the ECB accounts to lower the amount of central bank reserves by €1.

In the European system, reserves are viewed almost like bank deposits with the ECB, but to complicate the equation, there are actually two kinds of reserves dubbed ‘mandatory’ and ‘excess’. (For a more detailed explanation of the dual reserves system follow this ECB link.)

Any QT efforts from the ECB will only affect excess reserves rather than mandatory. Commercial banks are incentivised to use excess reserves, rather than hold them at the central bank, because the ECB charges for the privilege.

Under current settings the excess reserves penalty is relatively low due to asset quality tiering rules but, of course, that may change.

The ECB has yet to announce any QT schedule. In fact, the ECB is still engaged in QE bond-buying, albeit at a slower rate than previously; still pumping liquidity into a sodden system.

Any economic slow-down, or even an oil-driven recession, however, should see European banks carrying large excess reserves – a change in direction that will require the ECB to bring the anti-QE particle of QT into play.


Just as the Big Bang produced matter and anti-matter, a series of financial and economic crises have spawned both QE and its opposite, QT.

Although, as noted by European particle physics research laboratory CERN, the universe seems to make a puzzling distinction between matter and anti-matter: theoretically, the two opposites should’ve annihilated each other at birth, leaving a blank space where our cosmos clearly exists.

 “Understanding matter anti-matter asymmetry is one of the greatest challenges in physics today,” the CERN website says. “Any detectable difference between matter and anti-matter could help solve the mystery and open a window to new physics.”

Whether QT can exactly erase QE or leave a mysterious financial residue for markets to ponder is another matter.

Intellect with interest

“People underestimate the impact of a new reality”

Joseph Incandela, American particle physicist working at CERN

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  • The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

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