Fed Watching Redux

In our April 13, 2017, Wealth Watch entitled Fed Watching,” we suggested that “Fed watching” may become more interesting in the months ahead as the Fed shifted to tighter monetary policy. At that point, the Fed had raised rates for the second time in three months and said it would consider steps to unwind its balance sheet. No details were given.

Fast forward to June. In addition to another rate increase, the Fed reiterated its intention to unwind its balance sheet beginning later this year and finally provided more specifics. Essentially, the Fed will reduce its holdings of bonds by decreasing its reinvestment of principal payments. Initially, reinvestments will be decreased by $10 billion per month for the first three months. In the following three months, the decrease will be $20 billion per month, then $30 billion per month for three months, $40 billion per month for three months, and finally $50 billion per month going forward. Once the unwinding is fully implemented, the Fed’s balance sheet will shrink by $600 billion per year!

How did we get here?

Before we talk about the potential impact of the great unwind, let’s review how we got here. Prior to the financial crisis, the Fed’s balance sheet stood at $1 trillion. After reducing short-term interest rates to near 0% during 2008 with little effect, the Fed implemented the first of three quantitative easing (QE) programs to stimulate the moribund US economy. The Fed would buy US Treasury and mortgage-backed securities. QE1 began in December 2008 and ended in June 2010. QE2 lasted from November 2010 to June 2011. QE3 spanned from September 2012 until October 2014. When all was said and done, the Fed’s balance sheet had ballooned to $4.5 trillion! At its peak, the Fed was buying bonds as fast as the US Treasury could issue them to fund the US budget deficit.

Where do we go from here?

Since QE3 ended in October 2014, the Fed has maintained its balance sheet by reinvesting the proceeds of any bond that have matured. Now, as it embarks on unwinding its bond portfolio, the Fed will decrease those reinvestments as noted above. Even at the eventual rate of $600 billion per year, it will take years for the Fed to bring its balance sheet close to where it was pre-financial crisis, if ever.

How will this unwinding affect the bond market? It remains to be seen. Most likely, interest rates will rise. With the Fed no longer buying bonds as part of its reinvestment program, the demand for Treasury and mortgage-backed securities will fall as will the prices of those bonds. Since interest rates move in the opposite direction of bond prices, a fall in prices will likely cause interest rates to increase. At what speed and to what magnitude, it’s too early to know. It’s possible that the yield curve, which has recently flattened out, may steepen again.

Conclusion

What does all of this mean for your bond portfolio? As “Fed watching” gains momentum, we are again reminded of the bond market’s complexity. With rising short-term rates, Fed unwinding, and the potential for unforeseen events, diversification within bonds is as important as within stocks. Furthermore, striking a balance between the quest for returns and defense against rising rates is critically important. While we are confident that the proactive adjustments made to your bonds a year ago strike that balance, we continue to be vigilant going forward.