The Fed will huff and puff and blow your house down as it begins quantitative tightening

Quantitative easing (QE) has become synonymous with the COVID-19 pandemic. The lockdown hit could slow global economic growth and lead to a financial crisis.

To artificially create economic growth, central banks began buying up government bonds and other securities, and governments began printing more money to expand the money supply.

This was felt most prominently in the United States, where the Federal Reserve increased the rate of the dollar in circulation by a record 27% between 2020 and 2021. The Fed’s balance sheet reached approximately $8.89 trillion at the end of August 2022, an increase of over 106. % from $4.31 trillion in March 2020.

However, none of them were able to stop the financial crisis. Fueled by the ongoing Ukrainian civil war, the current crisis is slowly preparing for a full-blown recession.

To mitigate the impact of ineffective quantitative easing policy, the Federal Reserve has embarked on quantitative tightening (QT). QT, also known as balance sheet normalization, is the Fed’s monetary policy of lowering interest rates. monetary reserves by selling government bonds. Removing the Treasury from cash balances would remove liquidity from financial markets and, in theory, keep inflation in check.

federal total assets
Chart showing total assets held by the Federal Reserve from 2005 to 2022 (Source: Federal Reserve Board)

In May of this year, the Fed announced it would launch the QT and raise the Federal Funds Rate. Between June 2022 and June 2023, the Fed plans to mature approximately $1 trillion worth of securities without reinvestment. US Federal Reserve Chairman Jerome Powell estimates that this is equivalent to one rate hike of 25 basis points given the economic impact. At the time, the cap was set at $30 billion per month for Treasuries and $17.5 billion for the first three months of mortgage-backed securities (MBS).

However, increasingly worrying inflation prompted the Fed to double the pace of contraction in September, increasing it from $47.5 billion to $95 billion. This means that in one month he can expect $35 billion of mortgage-based securities to be offloaded. Markets seem more concerned about the Treasury, but offloading mortgage-backed securities could actually trigger a recession.

The Fed Risks Ditching Mortgage-Backed Securities

Mortgage-backed securities (MBS) have been an important part of the U.S. financial market for decades, but until the 2007 financial crisis, the general public was unaware of this financial instrument.

A mortgage-backed security is an asset-backed security backed by a series of mortgages. They are created by aggregating groups of similar mortgages from a single bank and sold to groups who package them together into securities that investors can purchase. These securities were considered sound investments prior to the 2007 financial crisis. Unlike bonds, which pay coupons quarterly or semi-annually, mortgage-backed securities pay monthly.

Following the 2007 housing market crash and ensuing financial crisis, MBS became too filthy for private investors. To stabilize interest rates and prevent further collapse, the Federal Reserve stepped in as the last buyer, adding his $1 trillion of MBS to the balance sheet. This continued until 2017, when some of his mortgage bonds expired.

The 2020 pandemic has forced the Federal Reserve (Fed) to buy new, adding billions of dollars of MBS to its portfolio to inject cash into a lockdown-stricken economy. With inflation soaring, the Fed is embarking on another offload to keep prices from rising.

In addition to allowing expiration, the Fed sells mortgage-backed securities in its portfolio to retail investors. When private investors buy these mortgage bonds, they pull cash out of the economy at large and should (in theory at least) help the Fed do exactly what it intended.

But the chances that the Fed’s plan will actually work are diminishing by the day.

Offloading $35 billion of MBS each month may appear to keep inflation in check in the short term, but it could hurt an already struggling housing market.

Since the beginning of the year, mortgage rates have risen from 3% to 5.25%. The jump from the fixed rate of 2.75% to 3% was enough to raise red flags for many. A surge to 5.25% and likely to rise further means hundreds of thousands of people could be forced out of the housing market. The severity of this problem becomes clearer when viewed as a percentage increase rather than as an absolute number. Interest rates are up 75% year-to-date.

A 75% increase in mortgage payments could leave many people in the market behind on their payments and put their homes at risk of foreclosure. If large-scale foreclosures, such as those seen in 2007, do occur, the US housing market will be flooded with new supply of homes.

Monthly supply of single-family homes and condominiums in the United States has increased since 2021, according to data from the National Association of Home Builders (NAHB). , has decreased significantly since the beginning of the year, and has decreased for eight consecutive months.

gave us household goods
Chart showing reversed NAHB housing market index compared to monthly supply of single-family homes and condominiums in the US (Source: @JeffWeniger)

Data from the National Association of Realtors show that US home prices have reached 2005 levels, suggesting that home prices may reach a similar peak as in 2006.

affordable housing supply
Graph showing housing affordability from 1981 to 2022 (Source: National Association of Realtors)

Shares of Redfin and Zillow, the two largest US real estate brokers, are down 79% and 46% since the beginning of the year. Problems in the housing market since last summer show that the “soft landing” the Fed is trying to achieve with the QT will not be a soft one. A new housing crisis may be on the horizon as more and more market conditions are almost perfectly consistent with those seen in 2006. In an attempt to stabilize financial markets, the Fed could inadvertently destabilize the housing market.

It is difficult to predict the impact of the housing crisis and economic recession on the cryptocurrency market. While previous market downturns have dragged cryptocurrencies, digital asset markets have been able to recover faster than traditional markets.

The crypto market could take another hit if a full-blown recession hits. However, the devaluation may encourage more people to look for alternative “real assets” and allow them to find what they are looking for in cryptocurrencies.

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