The days of easy monetary policy are coming to an end, as the Federal Reserve begins to reduce its $4.5 trillion balance sheet along with raising short-term interest rates.
Although inflation is quite low, we expect this monetary policy tightening will mean moderately higher bond yields and a firmer U.S. dollar.
While balance sheet reduction is expected to be gradual, the market may not have fully priced in a return to more “normal” monetary policy, raising the risk of a jump in yields.
We suggest investors limit average portfolio duration to mitigate the risk of rising interest rates, continue to limit exposure to international developed-market bonds, and prepare for higher volatility ahead.
At its September meeting, the Federal Reserve announced that it would begin the process of reducing its $4.5 trillion balance sheet by ceasing the reinvestment of principal on the maturing bonds that it holds. In that way, as bonds mature, they will “roll off” the balance sheet. The announcement was widely anticipated and produced very little reaction in the markets. However, it is significant in our view. After nearly a decade of very low interest rates and an expansion of the balance sheet to nearly 25% of gross domestic product (GDP) from 6% of GDP in 2007, the move signals another step toward a return to more normal monetary policy.
Based on the plan laid out by the Fed in June, the size of the balance sheet is set to decline over time. However, because a large proportion of bond maturations are lumped into the next few years, the plan will limit the dollar amount that will be allowed to roll off without reinvestment in each month. That way, there shouldn’t be a sudden increase in supply for the market to absorb. As the Fed steps back from buying bonds, other investors will need to step in. It’s possible that without the Fed as a reliable buyer, yields will have to move up to attract other investors.
Initially, the monthly cap is $6 billion for Treasuries and $4 billion for mortgage-backed securities (MBS). These caps will gradually increase each quarter until they reach $30 billion for Treasuries and $20 billion for MBS, where they will remain.
Size of the Fed’s balance sheet is set to decline
Note: Chart represents securities held outright by the Federal Reserve, excluding various liquidity facilities as defined by the Fed as very short-term Treasuries and excess securities.
Sources: Federal Reserve for historical longer-run reserves, as of 9/22/2017. Treasury projections are calculated using data from the New York Federal Reserve Bank, as of 9/20/17 for Treasury holdings, and the Federal Reserve’s June 14, 2017 publication “Addendum to the Policy Normalization Principles and Plans” for Treasury caps. MBS and agency debt projections are calculated using data from the New York Fed, as of 9/20/17 for MBS holdings, data from Bloomberg as of 9/28/17 for PSAs to estimate prepayments, and the Federal Reserve’s June 14, 2017 “Addendum to the Policy Normalization Principles and Plans” for MBS caps. PSA (pooling and servicing agreement) prepayment speed is a measure developed by the Bond Market Association that studies the rate of prepayment of mortgage loans. The model represents an assumed rate of prepayment each month of the then-unpaid principal balance of a pool of mortgages.
Estimating the pace of decline in the Fed’s Treasury holdings is fairly straightforward, but estimating the pace of decline in MBS is more difficult. Mortgage rates and the level of housing activity can affect the number of mortgage bonds that get retired every year through refinancing. We used the 20-year average pace of prepayments for our baseline assumptions. Even if the pace of prepayments slows due to rising mortgage rates, it doesn’t appear likely to have a big impact on the overall plan, because by next year the holdings should be under the maximum cap.
Treasury reinvestments will likely be affected by the monthly caps for years
Sources: New York Fed, as of 9/20/2017 for Treasury holdings. Federal Reserve’s June 14, 2017 publication “Addendum to the Policy Normalization Principles and Plans” for Treasury cap.
But given projected prepayment speeds, caps for mortgage reinvestments may not even be needed in a few years
Sources: New York Fed, as of 9/20/17 for Treasury holdings. Federal Reserve’s June 14, 2017 publication “Addendum to the Policy Normalization Principles and Plans” for Treasury cap.
What we don’t know is the end point—how large the Fed would like the balance sheet to be when it stabilizes. Various former and current Fed officials have indicated that they believe it is likely to be larger than in the past. Former Fed Chairman Ben Bernanke made the case last year that the balance sheet could be greater than $2.5 trillion going forward, to reflect the increasing size of the economy and to allow the Fed ample reserves to deal with another potential crisis. That point would likely be reached in six years and leave the balance sheet at about 13% of GDP—about halfway between its 2007 low and its 2014 peak.
Potential market impact
Even at a gradual pace, balance sheet reduction is a form of tightening in monetary policy. It is lowering the amount of reserves in the financial system. With fewer reserves, banks have less capacity to lend. When combined with rising short-term rates, the effect is greater since the cost of borrowing is going up on top of the banks’ capacity to lend. However, at current levels, there is still ample liquidity in the financial system and borrowers aren’t having any problem getting financing. Bank lending is growing at a 5% to 6% pace and corporate bond issuance is on pace to set another record for the sixth consecutive year. Also, foreign central banks in Europe and Japan have continued their bond-buying programs, keeping liquidity high. Overall, financial conditions remain very loose, in fact, looser than when the Fed first starting raising rates in December 2015.
Financial conditions have eased
Note: The Goldman Sachs Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
Source: Bloomberg. Goldman Sachs Financial Conditions Index (GSUSFCI Index), daily data as of 10/06/2017.
We see the potential for the unwinding of the Fed’s balance sheet to increase 10-year Treasury bond yields by as much as one percentage point (or 100 basis points) all else being equal. The Fed believes that the various quantitative easing (QE) programs have depressed the term premium by that amount, so it would make sense that unwinding QE might cause the term premium to rise. The “term premium” is the risk premium that investors receive for buying longer-term bonds instead of a series of short-term Treasury bills. That risk premium compensates investors for the possibility that short-term rates don’t follow the expected path implied by the markets, usually due to higher-than-expected inflation. If the term premium is negative, as it is now, it suggests that investors are willing to accept a lower yield on long-term securities in order to avoid the risk of rolling over their shorter-term investments during a period of uncertain and fluctuating short-term interest rates.
The 10-year term premium is still negative
Source: Bloomberg. Adrian, Crump & Moench 10-Year Treasury Term Premium (ACMTP10 Index), using weekly data as of 10/6/2017.
If the term premium increases gradually over a five-year time frame it would add about 15 to 20 basis points to 10-year Treasury yields per year. The Fed’s gradual approach is meant to mitigate the risk of a sudden jump in rates that could be harmful for the economy. However, there is always a risk that markets will react to the shift in direction more quickly than anticipated, resulting in higher yields sooner. In 2013, when then-Fed Chairman Bernanke mentioned the idea of the Fed reducing its bond buying, 10-year Treasury yields rose by one percentage point in just a few months’ time, a move referred to as the “taper tantrum.”
We don’t expect a repeat of the taper tantrum in the Treasury market because the plan has been so well-communicated. However, it’s possible that there could be a more adverse reaction in the MBS market than in the Treasury market, because the Fed’s buying has represented a bigger proportion of that market. Currently, the Fed holds about 29% of outstanding MBS, compared with about 14% of Treasuries outstanding.
However, we don’t see bond yields returning to levels seen prior to 2007 any time soon. Economic growth is still slow by comparison to pre-crisis levels, inflation is still below the Fed’s 2% target and other major central banks are still pursuing QE programs. Moreover, the prospects for growth and inflation should be the biggest drivers of bond yields going forward.
What to do?
In general, the Fed’s move to reduce its balance sheet by allowing bonds to mature over the next several years should be seen as a sign of the progress the economy has made since the financial crisis. If the process goes according to plan, it will likely mean a gradual rise in interest rates over the next few years. We suggest investors:
- Consider limiting the average duration in their portfolios to the short to intermediate term to mitigate the risk of rising interest rates as the program begins.
- Consider using bond ladders to spread out maturities of bonds in a portfolio, as a way to manage through a rising-interest-rate environment.
- Focus on high-credit-quality bonds, as volatility may pick up as the Fed reduces liquidity.