Quantitative tightening, usually shortened to QT, is what happens when a central bank shrinks the pile of bonds it bought during earlier crises. It is the reverse of quantitative easing, and while it rarely makes front-page news, it quietly affects bond yields, borrowing costs and the amount of money sloshing around the financial system.
Where QT comes from
After the 2008 financial crisis, and again during the pandemic, central banks such as the Federal Reserve, the Bank of England and the European Central Bank cut interest rates close to zero. When that was not enough, they created new money and used it to buy government bonds in huge amounts. That was quantitative easing, or QE. It pushed bond prices up and yields down, lowering borrowing costs across the economy.
The result was enormous central bank balance sheets, holding trillions of pounds, dollars and euros of bonds. Once inflation returned and rates went back up, central banks began to reduce those holdings. That process is QT.
How QT works
There are two ways to shrink a balance sheet. The gentler way is to let bonds mature without replacing them. When a bond reaches the end of its life, the government repays the central bank, and the money effectively disappears. The more aggressive way is to actively sell bonds back into the market before they mature.
The Bank of England stands out because it has done both, selling gilts as well as letting them mature. That means private investors have had to absorb more gilts at the same time as the government has been borrowing heavily, which many analysts think has added to upward pressure on UK yields. The Federal Reserve chose to let bonds roll off rather than sell, and it has since slowed and then brought its reduction to a close.
Why QT matters to traders
The main effect is on bond yields. When a central bank stops being a big buyer, or becomes a seller, someone else has to buy those bonds, and they usually want a higher return to do so. That can push up longer-term yields and steepen the yield curve. Our guide to term premium explains the extra return investors demand for holding long bonds.
QT also drains reserves from the banking system. If it goes too far, money markets can get tight, which can cause sudden spikes in short-term borrowing rates. Central banks watch for those signs and usually slow QT before problems build.
For shares and currencies the effects are indirect. Higher long-term yields make future profits worth less in today’s money, which can weigh on growth shares, and they can attract money into a currency.
Why it matters now
With 10-year gilt yields above 5 per cent and the UK Budget on Wednesday 28 October, the pace of the Bank of England’s gilt sales is part of the conversation about UK borrowing costs. The Fed’s decision the same evening will also be read for any comment on its balance sheet. Our Morning Market Brief covers both.
The bottom line
Quantitative tightening is the slow unwinding of years of central bank bond buying. It is less dramatic than a rate decision, but it can steadily push yields higher, so it is worth understanding if you trade bonds, currencies or rate-sensitive shares.
If you want to find out how you handle decisions like this, and where your own trading could improve, the free Samuel & Co Trading Trader Assessment is a sensible next step.
