Morgan Stanley believes that the Federal Reserve's end to quantitative tightening does not equate to the restart of quantitative easing.

Written by: Long Yue

Source: Wall Street Watch

The Federal Reserve's decision to end quantitative tightening (QT) has sparked widespread discussion in the market regarding its policy shift, but investors may not simply equate this move with the beginning of a new easing cycle.

According to a Morgan Stanley report, the Federal Reserve announced at its recent meeting that it would end quantitative tightening on December 1. This action came about six months earlier than the bank's previous expectations. However, its core mechanism is not the "massive liquidity injection" that the market anticipated.

Specifically, the Federal Reserve will stop reducing its holdings of Treasury securities but will continue to allow approximately $15 billion in mortgage-backed securities (MBS) to mature each month and flow out of its balance sheet. At the same time, the Federal Reserve will purchase an equivalent amount of short-term Treasury bills (T-bills) to replace these MBS.

The essence of this operation is an asset swap rather than an increase in reserves. Morgan Stanley's Chief Global Economist Seth B Carpenter emphasized in the report that the core of this operation is to change the "composition" of the balance sheet rather than to expand its "size." By releasing the duration and convexity risks associated with MBS into the market while purchasing short-term debt, the Federal Reserve has not materially loosened financial conditions.

Ending QT does not equal restarting QE

The market needs to clearly distinguish this operation from quantitative easing (QE). QE aims to inject liquidity into the financial system through large-scale asset purchases, thereby lowering long-term interest rates and easing financial conditions. In contrast, the current Federal Reserve plan is merely an adjustment within its asset portfolio.

The report points out that the Federal Reserve's replacement of maturing MBS with short-term Treasury securities is a "securities swap" with the market and will not increase reserves in the banking system. Therefore, interpreting it as a restart of QE is a misunderstanding.

Morgan Stanley believes that although the Federal Reserve's decision to end QT early has attracted significant market attention, its direct impact may be limited. For example, stopping the monthly reduction of $5 billion in Treasury securities six months early results in a cumulative difference of only $30 billion, which is minimal compared to the Federal Reserve's massive investment portfolio and the overall market.

Future balance sheet expansion is not "liquidity injection": merely a hedge against cash demand

So, when will the Federal Reserve's balance sheet expand again? The report suggests that, aside from extreme situations such as a severe recession or financial market crisis, the next expansion will be for a "technical" reason: to hedge against the growth of physical currency (cash).

When banks need to replenish cash for their ATMs, the Federal Reserve provides banknotes and correspondingly deducts from that bank's reserve account at the Federal Reserve. Therefore, the growth of cash in circulation will naturally consume bank reserves. Morgan Stanley predicts that in the coming year, to maintain stable reserve levels, the Federal Reserve will begin purchasing Treasury securities. At that time, the Federal Reserve's bond purchases will increase by an additional $10 billion to $15 billion per month, on top of the $15 billion used to replace MBS, to match the reserve depletion caused by cash growth.

The report emphasizes that the purpose of this bond-buying behavior is solely to "prevent a decline in reserves," not to "increase reserves," and thus should not be overly interpreted by the market as a signal of monetary easing.

The real key: The Treasury's bond issuance strategy

Morgan Stanley believes that for the asset market, the real focus should shift from the Federal Reserve to the U.S. Treasury.

The report analyzes that the Treasury is the key player in determining how much duration risk the market needs to absorb. The Treasury's issuance of new debt ultimately returns the reduced Treasury securities back to the market. The Treasury's recent strategy has leaned towards increasing the issuance of short-term bonds. The Federal Reserve's purchase of short-term Treasury securities may facilitate the Treasury's further increase in short-term bond issuance, but this entirely depends on the Treasury's final decision.

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