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FOMC Set to Start Quantitative Tightening - How Will Bonds, USD Respond?

FOMC Set to Start Quantitative Tightening - How Will Bonds, USD Respond?

Talking Points:

Fundamental Forecast for USD: Neutral

The big U.S. data point for this week was Thursday’s release of inflation for the month of August. And while this came-out in a rather encouraging format, with headline printing at 1.9% versus an expectation of 1.8% while core came-in at 1.7% versus the 1.5% estimate, bulls were unable to hold on to the previous week’s gains as sellers took over ahead of a pivotal Federal Reserve meeting next week. This better-than-expected inflation print is the second consecutive month of higher prices for the U.S. economy; and this comes after a troubling turn in the beginning of the year that saw inflation swan-dive from a 2.7% high in February down to a low of 1.6% in June. Normally – a print such as we saw yesterday would bring at least a day’s worth of strength into the Dollar; but the context with which we are currently operating can’t quite be considered normal as a huge FOMC meeting looms on the docket for next week, when the bank may announce the start of Quantitative Tightening.

U.S. Inflation Increases for Second Consecutive Month in August

Chart prepared by James Stanley

Wednesday brings a pivotal rate decision from the Federal Reserve in which the bank is expected to be the first major Central Bank to start Quantitative Tightening. During the Great Financial Collapse and recovery, the Federal Reserve’s Balance Sheet ballooned to $4.5 Trillion. And while this was a highly unusual or an ‘extraordinary’ level of accommodation, buying bonds in the open market and flushing the banks that sold those bonds with cash, it accomplished the Federal Reserve’s goal of quelling the sell-off during the Financial Collapse and keeping markets from plummeting in the immediate period thereafter. But it’s too early to call this mission accomplished as of yet, because now it’s time to put QE in reverse with QT (Quantitative Tightening, or the opposite of QE), and nobody really knows how markets will respond as we’ve never seen anything like it.

In May of 2013, the Fed first announced that they would begin to taper their $70 billion-per-month bond buying program, and fixed income markets convulsed in a situation that eventually became known as the taper tantrum. After numerous assurances from various Fed officials that any changes would be gradual, normalcy was eventually restored until we finally saw the Fed finish their bond purchases in October of 2014. At this point, the Fed had accumulated a $4.48 trillion portfolio largely consisting of treasury and mortgage-backed securities; and since then they’ve been re-investing coupon and principal payments as part of their open market operations. This has kept the heavy hand of the Federal Reserve as an active participant in two key areas of the bond market; and that heavy hand and the demand that it carries has helped to keep interest rates in the United States low.

The Fed is not taking QT lightly: They’ve previously announced that they weren’t going to invoke direct bond sales, and they were simply going to let maturing bonds ‘run-off’ of the balance sheet by not reinvesting coupons and principal payments by a set amount each month. This is going to start with $6 billion per-month in Treasuries and $4 billion per month in mortgage-backed securities, increasing by that same amount each month until the Fed is letting $30 billion-per month roll-off in Treasuries and $20 billion-per-month in mortgage-backed securities. For how long will this last? We don’t know that part yet, as the Fed hasn’t yet mentioned an ultimate target for the size of the balance sheet. We simply know that the Fed wants to tip their toe into the water to see if bond markets convulse in the way that they did in 2013/2014 as the biggest market player in the land starts to become less-long of one of the most important assets in the world.

The goal for Janet Yellen is stability. She’s previously said that balance sheet reduction will ‘run quietly in the background.’ The Fed also envisions being able to institute a dual-tightening mandate, whereby they’re not only letting the balance sheet diminish by not reinvesting bond proceeds, but also by continuing to hike rates in the effort of further normalizing policy. Markets don’t appear to be buying that thesis. The Fed first started talking about balance sheet reduction around their March rate decision, and since the week of that rate hike, the U.S. Dollar has been obliterated as sellers have taken-out more than -10.5% of the value in ‘DXY’. This sell-off has deepened even though the Fed continues to say that they want to hike rates four times going out to the end of next year, and even when they were one of the few major Central banks to hike rates in Q2.

U.S. Dollar via ‘DXY’ Daily: -12.3% Drawdown This Year, -10.5% Since March 14

Chart prepared by James Stanley

This bearish price action in the U.S. Dollar that’s shown up since that March rate hike appears to be clear evidence that markets are skeptical of the Fed being able to continue hiking rates while also tightening the money supply via balance sheet reduction. Given that balance sheet run-off is going to increase each month until we hit a target of around $50 billion/month, this is going to function as an increasing form of pressure on the money supply. Sure, the first $10 billion might not change matters much, but as bond traders and market participants prepare for the steadily increased amount of bonds that are going to be filtering into the marketplace via the Fed’s lessened demand, matters can change considerably, and this presents a very opaque backdrop for the U.S. Dollar in the near-term.

The forecast for the U.S. Dollar will be set at neutral for next week until more information can be had around how the Federal Reserve will begin the process of Quantitative Tightening and, perhaps more importantly, how markets are going to respond.

--- Written by James Stanley, Strategist for

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