Brian Erickson, Vice President, Fixed Income Research and Strategy, Ameriprise Financial
September 19, 2017
- The Federal Reserve is preparing to scale back its role in the bond market
- The new Fed direction could impact investors should interest rates increase
- A shift in interest rates could also affect mortgage borrowing costs
The Federal Reserve (the Fed) outlined a plan in June to reduce its securities holdings at a measured pace over the course of several years. This comes on the heels of several modest hikes in short-term interest rates controlled by the Fed since December 2016. It signifies the beginning of the end of nearly a decade of highly active Fed bond buying. The Fed kicked off the first so-called Quantitative Easing I (QE1) program in November 2008.
The Fed’s intervention following the financial crisis
The Fed expanded its balance sheet by 500% over the past decade, driven by multiple rounds of quantitative easing. The QE programs reflected the Fed’s efforts to support markets and asset values in the wake of the financial crisis.
Four rounds of bond purchases left $4.2 trillion of Treasuries and mortgage-backed securities (MBS) on the Fed’s balance sheet, up dramatically from $815 billion in July 2007.
The next phase
The plan recently announced by the Fed initially reduces its bond holdings by $6 billion of U.S. Treasuries and by $4 billion of mortgage-backed securities each month. Once the plan is fully phased-in, the pace of balance-sheet reduction would accelerate to $50 billion of securities rolling off each month.
The timing for when the Fed’s plan might begin has not been announced, but we estimate it could commence as early as October.
For context, the Fed purchased $85 billion of debt in the final round of bond buying known as Quantitative Easing III (QE3). The Fed will unwind its balance sheet at a more moderate pace by comparison, persisting over a period of several years.
The Fed has not yet disclosed its target for how much it will reduce its balance sheet. It has even suggested that the pace could be slowed if necessary to discourage a significant market reaction.
While the Fed is trying to keep the focus on the incremental nature of its plan, we believe the Fed is likely to cut its balance sheet in half; by more than $2 trillion over the course of five years.
We point out that the Fed’s balance sheet reduction plan signals the end of an era and its transition from major buyer to net seller in key market segments underlying the next chapter for fixed income markets.
As the Fed pulls back in its participation in the bond market, we anticipate demand for bonds to likely decline leading prices lower and yields higher. We believe the Treasury yields may settle in higher as markets price in the sheer magnitude of the Fed's multi-year plan.
Expect rates to trend higher
Though our expectation is for a modest-to-moderate rise in yields attributed to a reduction in the Fed’s security holdings, a pick-up in inflation could compound a rise in bond market yields. Inflation has been stubbornly low, frustrating consumers looking for wage increases and moderating the pace of the Fed’s withdrawal of monetary stimulus.
We remain watchful for how inflation data evolves from here and cognizant that a jump in inflation, though unlikely in our view, could prompt a broader correction in bond markets.
Are you ready?
We believe fixed income investors should be prepared for a rise in Treasury yields that could limit fixed income total returns. Investors should consider maintaining a diversified fixed income portfolio while holding reduced positions in Treasury and government debt. Total return investors may wish to shorten durations within fixed income allocations to reduce portfolio sensitivity to changes in interest rates.
Another consideration, rising 10-year Treasury yields also suggest higher home mortgage rates for consumers. The Fed’s stimulus over the past decade supported attractive financing terms for many consumers to purchase homes, and the reverse of the Fed’s support may send mortgage rates somewhat higher.
Contact your Ameriprise financial advisor to discuss if adjustments to your portfolio’s fixed income allocation or other mortgage strategies relative to your specific situation would be beneficial given the Fed’s direction.