We expect the Federal Reserve to announce by the end of this summer a plan to reduce its balance sheet by about $1.5 trillion. The prospect of such a large reduction in bond holdings has investors nervous about the potential impact on yields.
But we don’t believe it should be cause for alarm. The Treasury market should be able to absorb a gradual decline in the Fed’s bond holdings without pushing yields significantly higher. The impact on the mortgage-backed securities market might be greater, however.
If bond yields head higher during the next few years, it is more likely to be the result of stronger growth and inflation than the size of the Fed’s balance sheet.
The minutes of the Federal Open Market Committee (FOMC) meeting for March indicated that Federal Reserve policymakers were discussing strategies to reduce the size of the Fed’s balance sheet starting later this year. While the full details of the plan have not yet been spelled out, we have a good idea of the Fed’s thought process based on statements from various current and former members and a recently published paper by the New York Federal Reserve Bank, which provided updates on its projections for the path and timing of balance sheet reduction1.
Projected Federal Reserve System Open Market Account domestic securities holdings: Baseline by asset class
Notes: Figures are as of year-end. Figures for 2010-16 are historical settled holdings. Projected figures are rounded.
Source: Federal Reserve Bank of New York.
Some investors are worried that the size of the balance-sheet reduction—possibly as much as $1.5 trillion over the next few years—could mean sharply higher bond yields, as the Fed’s reduced demand for bonds potentially would lead to lower bond prices (and higher yields, which move inversely to price). In our view, however, if bond yields head higher during the next few years, it is more likely to be the result of stronger growth and inflation than the size of the Fed’s balance sheet.
A great expansion and a slow reduction
From 2008 to 2014, the Federal Reserve expanded its balance sheet from about $700 billion dollars to $4.3 trillion by purchasing Treasury and mortgage-backed securities (MBS) to hold on its balance sheet. There were three rounds of bond-buying programs, or “quantitative easing.” In all, the Fed’s balance sheet expanded from about 7% of U.S. gross domestic product (GDP) to a peak of 25% of GDP in 2014. Since ending quantitative easing in 2014, the Fed has been reinvesting the principal and interest from its bonds into new bonds, keeping the total quantity of bonds held the balance sheet at a historically high level.
The Fed’s balance sheet grew to $4.3 trillion after the 2008 financial crisis
Note: MBS (mortgage-backed securities) and Agencies (federal agency securities) refer to securities issued by the Federal National Mortgage Association (known as Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae).
Source: Federal Reserve, as of 5/22/2017.
The Fed is likely to announce a plan this summer to bring the balance back to a more normal level. However, we doubt it will go back to where it was prior to the financial crisis. In a recent blog post, former Fed Chairman Ben Bernanke indicated his belief that the Fed should keep its balance sheet larger than it was prior to the financial crisis, because there is more demand now for currency in circulation and reserves at banks and because it gives the Fed more policy options than simply setting short-term interest rates. A larger balance sheet would also reflect the economy’s growth. Bernanke estimated that the Fed should target a balance sheet of about $2.5 to $2.8 trillion, or about 12% of GDP.
With those guidelines in mind, assuming the Fed stops reinvesting principal and interest in new bonds in early 2018, we believe the Fed can reach the upper end of the target range in about five years. There are $782 billion in Treasury holdings maturing in just the next two years, and a total of $1.3 trillion maturing between now and 2021. Allowing those bonds to “roll off” the balance sheet would go a long way toward the Fed’s goal of a more normal-size balance sheet.
A significant portion of Fed-held securities will mature over the next seven years
Note: Chart reflects dollar amounts of securities on the Fed’s balance sheet that are expected to mature each year. Source: Federal Reserve Bank of New York, as of 5/23/2017. Securities represented include Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities and Treasury Floating-Rate Notes.
Estimating the pace of decline in MBS is more difficult, because a certain percentage of homeowners pay off their mortgages early through refinancings, especially if interest rates fall. However, when rates rise prepayments tend to slow down. Consequently, trends in mortgage rates, the economy and credit scores can increase or decrease the pace at which MBS will mature. Assuming a 10% prepayment rate, which is lower than the historical average, the New York Federal Reserve Bank has estimated that the Fed’s MBS holdings would shrink by $472 billion over the next five years. When combined with the $1.3 trillion in maturing Treasury bonds, the Fed would achieve its goal of reducing the balance sheet to $2.8 trillion by the end of 2021.
These estimates may be adjusted for economic conditions. If the economy were to fall into a recession, the Fed might resume reinvestments of principal and interest, or even go back to quantitative easing. Conversely, if growth and inflation picked up significantly, the Fed could sell bonds into the market to push up interest rates more rapidly. Having a large balance sheet increases the Fed options for setting policy.
Impact on interest rates
Despite the large size of the Fed’s holdings, we don’t expect a big impact on Treasury yields as it winds down the balance sheet. If the Fed communicates its strategy in advance and provides a clear pathway, the market is likely to adjust to the prospect of increased supply quickly. In the absence of Fed bond buying for reinvestment, the market will need to find private sector investors. Consequently, there could be some upward pressure on yields, especially since the Fed will also likely raise short-term interest rates at the same time due to improving economic growth.
How much could rates rise? It’s hard to separate the impact of quantitative easing from other market factors. The International Monetary Fund has estimated that the cumulative effect of the Fed’s $3.6 trillion in quantitative easing over the past decade has been to reduce 10-year Treasury yields by about 90 basis points, or 0.90%. Assuming that estimate is correct, if the Fed reduced its balance sheet by $1.5 trillion, the impact could be less than half the increase –about 42 basis points, or 0.42%. Spreading 42 basis points out over five years, we get an impact of about 9 basis points per year. That’s why we believe growth and inflation expectations are likely to be bigger drivers of bond yields than Fed balance sheet reduction.
Moreover, while it sounds like a huge amount for the market to absorb, the Treasury market is large, with about $12 trillion in debt held by the public. Finding buyers for approximately $300 billion per year in supply isn’t necessarily a huge feat. As an example, the market absorbed $330 billion in outright sales by foreign investors over the past year and10-year Treasury yields at about 2.25% are roughly where they were in the beginning of last year, despite two Fed rate hikes since then.
Mortgage rates may feel the impact more than the Treasury market. The Fed holds about $1.75 trillion in MBS, approximately 40% of the outstanding securities issued by Fannie Mae and Freddie Mac. Its reinvestments alone came to $387 billion in 2016. Until the Fed began hinting at reducing its balance sheet, MBS yields were only about 1% above Treasury yields of similar maturity. The yield difference has begun to widen recently, however, and if the Fed pulls back from the market, mortgage rates could move higher.
We do expect bond yields to move higher in the second half of 2017 based on our expectation for improving economic growth both domestically and globally, and slightly higher inflation. With the unemployment rate low and wages gradually moving higher, consumer spending will likely keep the economy on a steady growth track. Since consumer spending accounts for nearly 70% of GDP growth, we’re optimistic about the economy’s prospects in the second half of the year. That optimism, combined with the Fed’s likely policy moves suggest to us that 10-year Treasury yields could move up to the 2.75% region by year end.
What to do now
We expect the Fed to raise short-term interest rates two more times this year—most likely at the upcoming June 13-14 meeting, and perhaps again in September, depending on the economy’s performance. To mitigate the impact of rising interest rates, we suggest investors limit the average duration of their portfolios to the short-to-intermediate term. (Duration measures the sensitivity of a bond’s price to changes in interest rates. The higher the duration, the higher the potential price change.)
Our reasoning is that very short-term bonds will tend to have low volatility but also not offer much income. By holding short and intermediate term bonds, an investor can still generate income while not taking on the risk of holding long-term bonds.
As the chart below illustrates, the yield curve is very steep out to about seven years of maturity, and then it gets flatter. For example, the yield spread between three-year and seven-year Treasuries is about 60 basis points, or about 15 basis points per year of duration. In comparison, the difference between seven-year and 10-year maturities is only 18 basis points, or about 6 basis points per year of duration. For maturities over 10 years, the incremental yield offered is small relative to the duration risk.
The three- to seven-year maturity range tends to capture the steepest part of the yield curve
Source: Bloomberg as of 5/24/2017.
In general, our view is that investors should match the duration of their portfolios with the dates on which they expect to need the money. Bond ladders are also a strategy that can help smooth out some of the potential volatility in a fixed income portfolio. If you need help, a Schwab bond specialist or Financial Consultant can help analyze your fixed income holdings and build a portfolio that’s right for your financial plan.
1 Markets Group of the Federal Reserve Bank of New York, “Domestic Open Market Operations During 2016,”April 2017.