Morgan Stanley: Ending QT ≠ Restarting QE; the Treasury's debt issuance strategy is the key

Article by: Long Yue

Source: Wall Street Insights

The Federal Reserve’s decision to end quantitative tightening (QT) has sparked widespread discussion in the market about a potential policy shift, but investors may not should equate this move simply with the start of a new easing cycle.

According to a Morgan Stanley report, the Federal Reserve announced at its most recent meeting that it will conclude QT on December 1. This action is about six months earlier than the firm’s previous expectations. However, its core mechanism is not the market’s anticipated “large-scale liquidity injection.”

Specifically, the Fed will cease reducing its holdings of Treasury bonds but will continue to let approximately $15 billion of mortgage-backed securities (MBS) mature and roll off the balance sheet each month. Meanwhile, the Fed will purchase an equivalent amount of short-term Treasury bills (T-bills) to replace these MBS.

The essence of this operation is asset swapping, not new reserves. Morgan Stanley’s Chief Global Economist Seth B Carpenter emphasized in the report that the core of this operation is to change the “composition” of the balance sheet, rather than its “size.” By releasing the duration and convexity risks associated with MBS while purchasing short-term debt, the Fed has not substantially eased financial conditions.

Ending QT does not equal restarting QE

The market needs to clearly distinguish this operation from quantitative easing (QE). QE aims to inject liquidity into the financial system through large-scale asset purchases, thereby lowering long-term interest rates and easing financial conditions. The current Fed plan is merely an internal adjustment within its asset portfolio.

The report points out that swapping maturing MBS for short-term Treasury bonds is a “securities exchange” with the market and does not increase bank reserves. Therefore, interpreting this as a restart of QE is a misconception.

Morgan Stanley believes that although the decision to end QT early has attracted significant market attention, its direct impact may be limited. For example, halting the $5 billion monthly reduction six months early results in a total difference of only $30 billion, which is negligible relative to the Fed’s large portfolio and the overall market.

Future balance sheet expansion is not “money printing”: it is only to hedge cash needs

So when will the Fed’s balance sheet expand again? The report suggests that, except in cases of severe recession or financial market crises, the next expansion will be driven by a “technical” reason: hedging the growth of physical currency (cash).

When banks need to replenish cash at ATMs, the Fed provides currency and deducts the corresponding amount from the bank’s reserve account at the Fed. As a result, the growth of cash in circulation naturally consumes bank reserves. Morgan Stanley forecasts that over the next year, to maintain reserve levels, the Fed will begin purchasing Treasury bonds. The scale of these purchases will be an additional $10 to $15 billion per month beyond the $15 billion used to replace MBS, matching the reserve outflows caused by cash growth.

The report emphasizes that this bond-buying activity is solely to “prevent reserve declines,” not to “increase reserves,” and should not be overinterpreted by the market as a signal of monetary easing.

The real key: the Treasury’s debt issuance strategy

Morgan Stanley believes that for asset markets, the real focus should shift from the Fed to the U.S. Treasury.

The report analyzes that the Treasury is the key player in determining how much duration risk the market needs to absorb. The Treasury’s new debt issuance ultimately returns the bonds reduced by the Fed back to the market. Recently, the Treasury has been inclined to increase short-term debt issuance. The Fed’s purchases of short-term Treasury bills may facilitate the Treasury’s further issuance of short-term debt, but this entirely depends on the Treasury’s final decisions.