Developed countries' central banks collectively QT for the first time! The market faces a major test of tightening

Three weeks ago, the tragic collapse of global stock markets triggered by the Bank of Japan was just the prelude, and tightening is becoming a severe market test. Not only Japan, but central banks in developed regions are taking actions on Quantitative Tightening (QT), which the media refers to as the first collective QT of developed world central banks in history.

After the monetary policy meeting at the end of July this year, the Bank of Japan announced a 15 basis point rate hike, while also deciding to gradually reduce the central bank's bond portfolio by planning to decrease the purchase of government bonds by 400 billion yen each quarter. This means that following the Federal Reserve, the Bank of Canada, the European Central Bank, and the Bank of England, the Bank of Japan is also going to shrink its balance sheet. Although the operations of QT in various countries and regions differ, overall, they all involve withdrawing the liquidity injected into the economy by central banks through bond purchases during the COVID-19 pandemic.

Considering that in recent years, central banks in the UK and the US have triggered significant market reactions due to QT, the collective QT of central banks has now become a more threatening issue that investors need to be cautious about.

In September 2019, the US repo market experienced a brief yet severe liquidity shock, with one of the culprits of the "repo crisis" being the Federal Reserve's balance sheet reduction from 2017 to 2019. This was also a "dark history" of the Federal Reserve's first QT operation. Three years later in September 2022, shortly after the Bank of England raised interest rates by 50 basis points, the UK government announced its most radical tax reduction plan since 1972. The domestic financial market faced a triple attack on stocks, bonds, and exchange rates, prompting the central bank to “rescue the market” urgently, announcing "unlimited" temporary bond purchases and postponing this month's QT plan. UK bond prices made a sharp reversal, with the benchmark ten-year UK bond yield plummeting nearly 60 basis points from its previous 2011 high, injecting enthusiasm into global markets, with both stocks and bonds surging.

Federal Reserve Chairman Jerome Powell previously stated that the Fed has learned from the lessons of 2019 and promised to stop before problems arise. However, commentators believe that Powell's commitment does not guarantee a smooth passage through this round of QT, especially when investors are facing the collective "draining" of central banks in developed countries worldwide. Some recent signs of pressure in the financing markets have reinforced expectations that the Federal Reserve will end QT soon.

Steven Barrow, the G10 strategist at Standard Bank in London with forty years of experience in foreign exchange and fixed income strategies, warned:

"The Federal Reserve may run into trouble again, while other central banks have not yet been tested."

Barrow mentioned in a recent report the "Black Monday" global stock market sell-off on August 5th two weeks ago, stating that the sell-off peaked on August 5th, marking the most severe decline since 2020, which could be a warning signal of the potential impact of QT Barrow's report points out that in earlier years, major central banks injected cash into the economy by purchasing bonds, with some of it being used to invest in higher-risk assets such as stocks. Now, central banks are reducing these asset reserves, posing a challenge to investors.

Regarding Quantitative Tightening (QT), the Bank of Canada, which started action over two years ago, has been more aggressive than the Federal Reserve. Analysis from the Canadian Imperial Bank of Commerce suggests that the Bank of Canada's balance sheet reduction plan has disrupted the operation of the short-term funding market this year, forcing the central bank to intervene regularly. However, last month, the Bank of Canada's Deputy Governor Carolyn Rogers hinted at continuing QT as the balance sheet has not yet "normalized."

On the other hand, the Bank of England has taken the most aggressive approach to balance sheet normalization by actively selling bonds in its investment portfolio, not just reducing reinvestment in maturing bonds. To address market liquidity issues, the Bank of England encourages domestic banks to use a range of loan tools to obtain cash from the central bank when needed, known as the demand-driven system.

Compared to other central banks, the Bank of Japan's stance appears less firm. Earlier this month, the Bank of Japan unveiled a combination of rate hikes and balance sheet reduction, causing a market earthquake with historic plunges in Japanese stocks. Subsequently, central bank officials reassured the market and temporarily "surrendered." Bank of Japan Deputy Governor Shinichi Uchida stated on August 7th that the central bank will not raise rates when the market is unstable and currently needs to firmly implement loose policies.

After Uchida's statement, both Japanese and US stocks rebounded, indicating that his remarks were well-received by investors. However, subsequent analysis by Wall Street News suggests that this does not solve the fundamental problem. If the Bank of Japan does not raise rates, yen carry trades will resurface, and inflation and a weak currency will continue to erode the purchasing power of the Japanese people. The central bank is in a dilemma, and the focus now shifts to whether other major economies like the US are heading towards a recession.

Furthermore, some analysts believe that Japan has factors more concerning than economic recession, with consumption and investment possibly being suppressed. Uchida's speech indirectly acknowledges that the Bank of Japan's rate hike was a policy mistake, which could jeopardize the relationship between the Japanese government and the central bank.

Given the sharp increase in public debt levels in many countries during the COVID-19 pandemic, some observers believe that these governments may pressure central banks to reduce QT and maintain support for the government bond market. Stephen Jen, CEO of Eurizon SLJ Capital, raises this question: with governments urgently needing public financing and issuing bonds, even if not all governments, this is the situation for most governments. Faced with large-scale bond issuance, how can central banks fully implement QT? If the market is unstable, it will be even more difficult to fully implement QT. Haegeli, Chief Economist at the Swiss Re Institute in Zurich, predicts that if global QT continues until 2025, it is likely to continue to trigger soaring volatility