The US Federal Reserve has signalled it could begin shrinking its massive $9 trillion balance sheet this year, reversing years of asset purchases designed to support economic recovery following the Global Financial Crisis and the pandemic.

The hawkish shift took markets by surprise. Revealed in minutes from the Fed's December policy meeting, released 5 January, the documents also showed officials discussed raising rates “sooner or at a faster pace” than initially anticipated.

Stock and bonds promptly sold off. Three weeks of losses have sent first the tech-heavy Nasdaq and now the S&P/ASX 200 into correction territory, defined as a decline of more than 10% from the previous high.

Known as “quantitative tightening”, the policy is the mirror image of “quantitative easing”, the mass purchasing of bonds and other securities by central banks to drive down long-term interest rates and boost credit.

Here is a guide to the latest acronym to worry markets, what it means for equities and how it could soon arrive in Australia.

Why now?

The Federal Reserve is winding back its extraordinary support in response to rising inflation and a strong economic recovery after the pandemic.

Monetary stimulus since the pandemic has come in two forms: near-zero interest rates and quantitative easing.

But with US consumer prices increasing at their fastest rate in 40 years and the labour market nearing “full employment”, policymakers want to reverse course.

Interest rates are already tipped to rise, with Fed officials signalling four or more rate hikes this year. Market participants expect the first in March. QE asset purchases are also set to end then, at which point the Fed will own almost $9 trillion in assets, half bought since the pandemic began.

Reducing those holdings is the next step. The Fed’s decision-making committee announced guidelines for QT on Thursday, saying it expects to start once rate hikes have begun. No firm timeline is in place. Market participants say a move is possible in the second half of the year.

How will it work?

In guidelines published Thursday, the Fed expressed its preference for a policy called “runoff”, where the central bank stops reinvesting the proceeds from maturing bonds.

Today, the Fed recycles the money from maturing bonds into new assets. This keeps its total quantity of holdings steady. By letting bonds mature without reinvesting the proceeds, runoff will slowly reduce the number of assets on the Fed’s balance sheet.

An alternative would be to sell bonds and other securities directly, but the Fed has said it "primarily" intends to reduce its holdings via runoff.

Officials are likely to start small and cap the total monthly runoff to avoid spooking bond markets accustomed to the Fed’s buying presence. In comments two weeks ago, committee member Raphael Bostic said he favoured $100 billion a month.

How will it impact markets?

QT reverses the stimulus engineered through quantitative easing. Central bank QE programs bought trillions in bonds and other securities to lower yields, which fall as prices rise. Low yields stimulated borrowing and boosted equity valuations as the purchases pumped cash into the banking system.

Years of quantitative easing made central banks major players in the government debt markets at the foundation of the financial system. As of December 2021, the Fed owned roughly a quarter of the $23 trillion dollar US Treasury market. At home, the Reserve Bank owns about a third of the $800 billion federal government bond market.

By ending purchases, central banks are removing a huge source of demand from bond markets. That has the potential to increase bond yields, raise borrowing costs and squeeze equity valuations.

“If the RBA is not out there buying bonds, not supporting the price of bonds, other things being equal, yields go up because a big buyer has been removed from the market,” says Stephen Miller, an adviser at GSFM funds management.

“That is what is going to happen when the Fed stops its quantitative easing program as well. The same when the European Central Bank does it and when the Bank of England does it.”

Bond yields are already rising in anticipation of the change. Benchmark 10-year government bond yields in the US and Australia are up 25% and 29% in the last month, respectively.

This is not the first time the Fed has cut down its balance sheet and bad memories from the previous instance may also be weighing on markets. When the Fed last began QT in 2017, it removed $600 billion over two years before an interest rate spike in short-term borrowing markets signalled too much cash had been withdrawn. The program was shelved in late 2019.

Technology to feel the brunt first

Stocks most vulnerable to higher bond yields, such as technology, will be first to feel the impact of shrinking central bank balance sheets, says Miller.

In the case of technology stocks, a significant part of company value is in future earnings. As investors discount those future earnings at a higher rate (due to higher bond yields), the present value for these stocks falls further and faster than the broader market.

US technology stocks have been at the vanguard of the selloff, with the Nasdaq Composite down 14.5% this year, compared to 9.3% for the broad-market S&P 500.

Other sectors likely to struggle amid higher interest rates include infrastructure and real estate investment trusts (REITS). Characterised by stable or fixed payments, these “bond surrogate” sectors become less attractive to investors as yields rise and income from fixed interest improves, says Graham Hand, managing editor at Firstlinks.

Reserve Bank could lead the way

All eyes are on the Federal Reserve, but a reduction in the Reserve Bank’s $350 billion portfolio of bonds could be set in motion as soon as next week.

Governor Philip Lowe is under pressure to announce an end to new bond purchases at the bank’s 1 February meeting after data released this week showed inflation hit RBA forecast levels years ahead of schedule.

The $4 billion a week bond buying program will likely be axed next week, says Peter Tulip, chief economist at the Centre for Independent Studies, previously of the Reserve Bank and Federal Reserve.

He believes Lowe will discuss plans for reducing the balance sheet but hold off formally announcing a runoff.

Others think the bank could move quicker. With the Fed discussing balance sheet reduction openly, the RBA may be comfortable ending QE and announcing a policy of “runoff” at the same time, says Miller.

“It will be a lot more comfortable abandoning quantitative easing and going to a form of quantitative neutrality [balance sheet runoff] now that it knows that most other central banks are going to do the same thing,” he says.