(Valerie Plesch/Bloomberg/Getty Images)
Wednesday's Federal Reserve policy decision will likely be pretty boring for investors — officials are widely expected to keep interest rates the same, just as they have since July 2023.
But some savvy traders are getting excited about another key decision. They think that the Fed may curtail its quantitative tightening (QT) program — that's the selling off of its assets to decrease money supply and increase interest rates — by as much as half.
What's happening: The Fed bought a ton of government-backed bonds between 2020 and 2022 to help support economic recovery after the pandemic-induced recession. Those purchases ended up pushing down interest rates in certain parts of the economy, like housing and auto sales.
In mid-2022, as inflation soared higher, the Fed reversed that and began unloading those bonds.
The Fed currently lets up to $60 billion in Treasuries mature each month without replacing them, reducing the amount of money circulating in the economy. The idea is that QT can help exert some downward pressure on prices.
But there's also some downside to the practice — changing the amount of liquidity in the economy and redirecting that money could have some major consequences.
As JPMorgan Chase CEO Jamie Dimon pointed out in his annual letter to shareholders last month, "we have never truly experienced the full effect of quantitative tightening on this scale." The current pace of QT is draining more than $900 billion in liquidity from the system annually, he said, adding, "I am more worried [about it] than most."
QT reduces the amount of money in the banking system, leading to higher interest rates and tighter monetary conditions, but last time the Fed implemented such a program in 2019, some banks fell very short of reserves.
That led to a "repo crisis", where the interest rates for overnight loans between banks spiked unusually high. The Fed had to intervene and provide liquidity to bring down those repo rates.
Fed Chair Jerome Powell doesn't want a repeat of 2019 and said at his last press conference that QT would be scaled back soon. The minutes of the March policy meeting show that many Fed officials expect to lower the rate of QT to $30 billion, half of where it currently sits.
What it means: "May 1 is set to be a big day in the bond market," Evercore ISI's Krishna Guha and Marco Casiraghi wrote in a recent note.
If the Fed does ease up its tightening policy, "financial markets will likely see the taper of the QT program as bullish for riskier investments like stocks and bonds at the margin," wrote Bill Adams, chief economist for Comerica Bank, in a note on Tuesday.
That's because a taper should send bond prices higher, and interest rates lower.
The risk, wrote Bank of America analysts on Tuesday, "is skewed to the upside for stocks, in our view, especially given a potential QT taper announcement."
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