'This Will Come Home To Roost': Warning Investors Not Prepared For QT Impact

The QT process began in October 2017 when the Federal Reserve announced it would start reducing its "gigantic" $4.5trn balance sheet.

This significant moment started the reversal of the quantitative easing (QE) process, which central banks implemented amid the Global Financial Crisis to support markets and prevent the collapse of the financial system.

As a side-effect, QE has created distortions in the market by holding up asset prices, helping to extend the multi-decade bull market in bonds and dampening volatility, while at the same time increasing the amount of debt in the system.

However, with the process concluding in the US and drawing to an end last year in Europe when the European Central Bank stopped its asset purchasing programme, questions remain over the impact of QT as investors enter uncharted territory.

Liquidity risk

There are a number of challenges to navigate, said investment commentators, as a result of the tightening, including reduced liquidity.

Research group CrossBorder Capital, in its January Global Liquidity report, warned liquidity is falling at its fastest rate since 2008 as central banks engage in a "twin-tightening" of simultaneously hiking rates and shrinking their balance sheets.

These monetary conditions, the report said, would cause the world economy to slow over the next three to six months and lead to a "massive" loosening of monetary policy later this year, a reversal of expectations seen last year when four rate hikes were predicted in 2019 from the Federal Reserve.

Prepare for 'strange' occurrences as liquidity concerns overlooked

Earlier in January, the Federal Open Market Committee minutes revealed a more dovish Fed with officials prepared to put rate hikes on hold until there is more clarity on the risks to global growth and the US economy, with this playing out at the Fed's January meeting.

Markets are now pricing in a 71.2% chance that rates will stay between 2.25% and 2.5%, a 15% chance of one hike, while expectations of a rate cut are 15%.

"All around is crashing," CrossBorder Capital warned in its report. "Already risk asset markets are skidding, in response to tight liquidity, and economic slowdown and probable recessions lie ahead.

"The future looks especially bad for those economies, firms and institutions that have spent the last decade kicking the proverbial debt can down the road. Investors should start to anticipate a massive monetary easing in 2019 that tries to reverse what may inevitably prove to be a hard economic landing."

Oxford Economics: Major liquidity drain may fuel bond market vulnerabilities

Furthermore, Abhi Chatterjee, head of asset and risk modelling at Dynamic Planner, said the lack of liquidity in the market was making investment decisions harder and harder.

The QE years, where there was a huge amount of liquidity in the system, he said, meant investors could practically buy anything without having to make a decision.