The Fed is about to start boosting financial markets again. Here's why.

By Vivien Lou Chen

Investors only focused on interest-rate cuts may miss another important move right on the horizon

Federal Reserve Chair Jerome Powell said the central bank plans to bring a pandemic-era program to an end on Dec. 1.

Investors focused on the Federal Reserve's midweek policy decision to cut interest rates by a quarter point - and on the chances of no further rate reduction in December - may be overlooking another critical development set to occur in the final month of this year.

The central bank said it will soon end its efforts to shrink its now roughly $6.6 trillion balance sheet under a program known as quantitative tightening, or QT, which began in 2022 as a way to supplement inflation-driven interest-rate hikes.

This announcement came as a bit of a surprise to some market participants, even though Fed Chair Jerome Powell indicated just over two weeks ago that the program might end in the "coming months." As recently as early September, large banks and other market participants had expected January to April 2026 to be the end date for the central bank's balance-sheet reduction effort.

Ending the program as of Dec. 1 is just another way for Fed officials to ease financial conditions, albeit through different channels than a rate cut would. Changes to the Fed's balance sheet impact the plumbing of the financial system in a way that most investors aren't likely to notice unless something breaks down.

The decision to bring the program to an end came ahead of the Treasury Department's quarterly refunding announcement next week. That matters to investors for a number of reasons.

One reason is that it could prompt market participants to shift into areas of the financial market such as stocks and short-term funding markets, helping to ease liquidity strains in the latter, according to FHN Financial macro strategist Will Compernolle in Chicago. Another reason is that it gives the U.S. Treasury a greater ability to build up the cash balance in its general account and to fund operations, he noted.

All that ideally helps the federal government and the plumbing of the financial system run more smoothly, without throwing a wrench in markets.

With the Fed no longer reducing its aggregate securities holdings as of Dec. 1, it stops draining liquidity from the financial system and instead reinvests proceeds from maturing securities, effectively injecting them back into the market.

Of note, the central bank said on Wednesday that it would be reinvesting all principal payments from its holdings of agency securities into Treasury bills, as well as rolling over at auction all principal payments from its holdings of Treasurys.

Fed buying bills

"When the Fed's balance-sheet shrinkage is happening, securities are maturing that need to be absorbed by the private market. When the Fed stops that process, the market doesn't have to absorb securities at the same pace, and private-market investments can go to other areas such as risk assets and short-term overnight funding markets," Compernolle said via phone on Friday.

Wrapped up in all of this is the Treasury's quarterly refunding announcement next week. "The Treasury forms estimates for how much cash it wants in its general account, and it now has more wiggle room to build up its cash balance since it will no longer be competing with the Fed for investors' funds as of the end of the year, especially in Treasury bills," the strategist said. In addition, the Fed is going to become a "willing buyer, soaking up some of the demand for T-bills."

The Fed's balance sheet grew to a nearly $9 trillion pandemic-era peak as of mid-2022, after the central bank bought big chunks of long-duration mortgage-backed securities and Treasurys to help lower long-term interest rates, make it cheaper to borrow and stimulate demand.

The central bank then began shrinking its gargantuan balance sheet in June 2022 through a process known as quantitative tightening to combat high inflation and tighten financial conditions. The Fed's QT efforts were a significant factor that contributed to a decline in U.S. stock prices that year and significant losses in the bond market.

While 2022 was a historically bad year for both stocks and bonds, this year is different, with the U.S. equity market repeatedly reaching fresh record highs and Treasury-market volatility falling to the lowest levels since late 2021. The end of QT in December should theoretically create an environment that supports equities, by improving overall market liquidity and lowering long-term Treasury yields.

"For every dollar of Treasurys and mortgage-backed securities that the Fed rolled off its balance sheet, that was a dollar of government-backed bonds that private investors would have had to purchase," said Bill Adams, chief economist of Comerica Bank in Dallas. "So now that the Fed is no longer reducing its bond holdings, more of that private investment flow will go into assets that fuel the economy."

The end of QT could "translate into more liquidity for financial markets and more private investment funds going into risky assets over a period of time," Adams added.

Yields are rising, not falling

Meanwhile, long-term Treasury yields keep climbing despite the Fed's quarter-point rate cut on Wednesday, after Powell pointed to "strongly differing views" among policymakers about what they will do in December. That may not be music to the ears of the White House, which has been vocal about wanting to see lower mortgage rates to help boost the stalled housing market.

Related: This long-shot move could get the 30-year mortgage rate to 5% next year, says BofA Global

Equity markets ended October's final trading session on a solid note, with investors appearing to be encouraged by the latest corporate earnings results. All three major stock indexes DJIA SPX COMP closed higher for the day, the week and the month. Treasury yields finished little changed on Friday; for the week, however, 10-year BX:TMUBMUSD10Y and 30-year Treasury yields BX:TMUBMUSD30Y rose by 10.4 basis points and 8.3 basis points, respectively, to three-week highs of 4.1% and almost 4.7%.

De facto rate cut?

Even if the Fed skips a December rate cut, the end of QT ahead of 2026 could give investors what is essentially the equivalent of a quarter-point rate cut anyway, according to John Luke Tyner, a portfolio manager at Alabama-based Aptus Capital Advisors.

"It certainly should help alleviate some of the plumbing pressures with bank reserves, as well as continue to manage the supply and, more importantly, the duration of the Treasury issuance," Tyner said in an email to MarketWatch.

Not everyone agrees with such a direct comparison, however. Economist Derek Tang of Monetary Policy Analytics in Washington sees things differently.

The end of QT compounds the impact of any rate cut by "reinforcing a lot of the risk appetite in equities," Tang said via phone. "Now that the end of QT is guaranteed, we have certainty." But he regards the Fed's decision as more of an "incremental change" in the Fed's balance-sheet policy, since it simply moved the plan forward by about three to six months, relative to what market participants had expected in September.

Still, the end of QT will likely have an impact on the Treasury Department's Nov. 5 quarterly refunding announcement because it could influence how much the government thinks it can issue in short-term T-bills.

Tang said the Treasury "will probably take into account what the Fed is thinking and start asking questions like, 'Can we issue more bills because the Fed is willing to absorb more of them?'"

Separately, T-bill-hungry money-market funds reached a record $7.42 trillion in assets for the week that ended on Wednesday, according to the Investment Company Institute. This record is a reflection of the demand that exists for Treasury bills, and supports the idea that the Treasury Department has more "wiggle room" to build up its cash balance by borrowing from investors, Compernolle said.

-Vivien Lou Chen

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