The liquidity contraction plan that began in 2022 is coming to an early end, which not only means that the financial system will regain fresh capital but may also inject new momentum into risk assets. As interest rate cut expectations fluctuate, this 'implicit easing' is becoming a variable that cannot be ignored by the market. While investors are closely watching the Federal Reserve's decision to cut rates by 25 basis points last week, as well as signals that rate cuts might pause in December, they may be overlooking another key shift that is about to occur in the last month of this year.
The Federal Reserve has stated that it will soon end its balance sheet reduction plan, which amounts to approximately $6.6 trillion—this policy, known as quantitative tightening (QT), began in 2022 with the aim of tightening financial conditions through inflation-driven interest rate hikes. Although Fed Chairman Powell hinted just over two weeks ago that the plan might soon come to an end, this announcement still caught some market participants by surprise. Until early September, large banks and other market participants expected the Fed's balance sheet reduction actions to continue until January to April 2026.
Ending the QT plan on December 1 will serve as another way for Federal Reserve officials to ease financial conditions, although its channel of effect differs from rate cuts. Changes in the Federal Reserve's balance sheet will impact the infrastructure of the financial system in a way that most investors find difficult to perceive, unless the system experiences a malfunction.
The decision to end QT came just before the Treasury's quarterly refinancing announcement this week. This is significant for investors.
FHN Financial Macro Strategist Will Compernolle pointed out that this could prompt market participants to shift towards financial sectors such as stocks and short-term financing markets, helping to alleviate liquidity pressures in the latter; secondly, it would empower the U.S. Treasury to better fill its general account cash balances and provide funding for operations. Ideally, all of this will help the federal government and financial system infrastructure operate more smoothly without causing disruptions in the market.
As the Federal Reserve stops reducing its total securities holdings effective December 1, it will cease to withdraw liquidity from the financial system and will reinvest the proceeds from maturing securities, effectively re-injecting funds into the market. Notably, the Federal Reserve stated last Wednesday that it would reinvest the entire principal of the agency securities it holds into Treasury bonds and extend the entire principal of the Treasury bonds it holds in auctions.
Federal Reserve bond purchase logic
“When the Federal Reserve implements balance sheet reduction, maturing securities need to be absorbed by the private market. Once the Federal Reserve stops this process, the market no longer needs to absorb securities at the same pace, allowing private market investments to flow into risk assets and other areas such as short-term overnight financing markets,” Compernolle explained over the phone last Friday.
All of this is closely related to the Treasury's quarterly refinancing announcement this week. The strategist noted: “The Treasury will estimate the cash size needed for its general account, and since it no longer needs to compete for investor funds with the Federal Reserve (especially in the Treasury bond sector) after the end of the year, it now has greater flexibility in replenishing cash balances.” Furthermore, the Federal Reserve will become a “voluntary buyer, absorbing some of the demand for Treasury bonds.”
The Federal Reserve previously engaged in massive purchases of long-term mortgage-backed securities and Treasury bonds to help lower long-term interest rates, reduce borrowing costs, and stimulate demand, causing its balance sheet to peak at nearly $9 trillion during the pandemic in mid-2022. Subsequently, the central bank initiated a process known as quantitative tightening in June 2022 to address high inflation and tighten financial conditions. The Federal Reserve's QT efforts were a significant factor leading to declines in U.S. stock prices and massive losses in the bond market that year.
Although 2022 was historically a terrible year for both the stock and bond markets, this year presents a different situation — U.S. stocks have repeatedly hit new highs, and the volatility in the Treasury bond market has fallen to its lowest level since the end of 2021. Ending QT in December could theoretically create an environment supporting the stock market by improving overall market liquidity and lowering long-term Treasury yields.
Dallas Federal Reserve Bank Chief Economist Bill Adams stated: “Every dollar of U.S. Treasury bonds and mortgage-backed securities that the Federal Reserve is shedding from its balance sheet originally needed to be purchased by private investors. Now that the Federal Reserve has stopped reducing its bond holdings, more private investment funds will flow into assets that drive economic growth.” He added that the end of QT may “translate into more liquidity in financial markets and more private investment funds flowing into risk assets in the near future.”
Yield rises instead of falling
Despite the Federal Reserve cutting rates by 25 basis points last Wednesday, long-term Treasury yields continued to rise — previously, Powell pointed out that policymakers had “serious disagreements” over December actions. This may not be welcome news for the White House, which has openly expressed a desire to see mortgage rates decline to boost the stagnant housing market.
The stock market closed steadily on the last trading day of October, with investors seemingly encouraged by the latest corporate earnings. The three major indices closed higher for the day, week, and month. Treasury yields were virtually unchanged last Friday, but the 10-year and 30-year Treasury yields rose by 10.4 and 8.3 basis points respectively over the week to three-week highs of 4.1% and nearly 4.7%.
Implicit rate cut?
John Luke Tyner, a portfolio manager at Aptus Capital Advisors in Alabama, believes that even if the Federal Reserve pauses rate cuts in December, ending QT before 2026 could still provide investors with an effect equivalent to a 25 basis point rate cut. In an email to MarketWatch, he stated: “This undoubtedly helps alleviate the underlying pressure on bank reserves and continues to manage the supply of Treasury bond issuances, more importantly, managing its duration structure.”
However, not everyone agrees with such a direct analogy. Derek Tang, an economist at Washington Policy Analysis, holds a different view. He said over the phone that the end of QT amplifies any rate cut effects through “strengthening risk appetite in the stock market,” stating, “Now that the end of QT is certain, we have certainty.” However, he views the Federal Reserve's actions more as a “gradual adjustment” of balance sheet policy, as it has only brought forward market expectations by about three to six months since September.
However, the end of QT is likely to impact the Treasury's quarterly refinancing announcement on November 5, as it may alter the government's assessment of the issuance scale of short-term Treasury bonds. Tang stated that the Treasury “is likely to consider the Federal Reserve’s intentions and begin asking questions like ‘Since the Federal Reserve is willing to absorb more Treasury bonds, can we issue more?’.”
According to data from the Investment Company Institute, the demand for Treasury bonds has led money market funds to reach a record of $7.42 trillion in assets for the week ending last Wednesday. Compernolle noted that this record reflects the demand for Treasury bonds in the market and supports the view that the “flexibility” for the Treasury to fill cash balances through borrowing from investors is expanding.
