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Fixed-Income Insights

Will the impact of the U.S. Federal Reserve’s reduction of bond purchases really be “like watching paint dry”?

 

In Brief

  • Are investors too complacent about the potential impact of the U.S. Federal Reserve’s (Fed) efforts to normalize its balance sheet, expected to begin in October?
  • While Fed officials have played down the potential impact of its plans to reduce monthly purchases of U.S. Treasuries and mortgage-backed securities (MBS), the move could introduce some volatility in financial markets.
  • How? The reductions increase significantly over the Fed’s contemplated time frame. Since the Fed has helped absorb demand for available Treasuries, its reduced role in the market could pressure yields higher.
  • Further, reduced purchases of MBS could result in wider spreads, and higher mortgage rates, pressuring the U.S. housing sector.
  • Developments on the economic, political, and market fronts during the Fed’s contemplated launch of normalization in October also may contribute to market volatility and investor reaction.
  • The key takeaway: The rollout of the Fed’s balance-sheet normalization effort may have a greater market impact than investors currently believe.

 

Normalization of the U.S. Federal Reserve’s (Fed) balance sheet seems likely to begin in October. This long-awaited reduction in securities purchases, referred to as qualitative tightening (QT), could unfold even as low inflation potentially delays an interest-rate hike projected for December.

With the move frequently discussed by Fed chair Janet Yellen and other officials of the central bank, investors seem complacent about the consequences of a gradual reduction of the Fed’s bond portfolio. (The Fed first began purchasing bonds as part of an economic stimulus effort in December 2008.) According to Bloomberg, 10-year U.S. Treasury yields actually are lower since the Fed described its balance-sheet normalization plan on June 14, 2017. Is the reduction in Fed holdings of Treasuries and mortgage-backed securities (MBS) the non-event the Fed portrays—or could the process produce a “tightening tantrum” in the market that pressures longer-term rates higher, widens MBS spreads, and steepens the yield curve? 

The difference between the market’s current benign expectations and a more volatile result could be influenced by other concerns in October, including equity valuations, congressional debt-limit debates, and a potential shift in European monetary policy. Analysis suggests that investors should be on guard for more volatility in the markets than implied by the recent stability in 10-year Treasury yields.  

Back to Normal
The plan by the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), to normalize its $4.4 trillion balance sheet was described in a communiqué released after its meeting on June 14. Although no start date was identified (the release characterized it as “relatively soon”), and no specific portfolio size was targeted, the plan detailed the size and subsequent increases in monthly portfolio reductions that investors can expect. Reinvestment of portfolio principal initially will be reduced by $10 billion per month, for the first three months, increasing by $10 billion per month for each of the next four quarters, until reinvestments are reduced by $50 billion per month.

The initial $10 billion target will be achieved by reductions of $6 billion in Treasury purchases and $4 billion in purchases of MBS.  By the end of the first 12 months of the program, the Fed will have reduced its purchases by a cumulative total of $300 billion—$180 billion in Treasury securities and $120 billion in MBS. The second year, and those subsequent, would reflect purchase reductions of $600 billion per year: $360 billion in Treasuries and $240 billion in MBS.

While the initial reductions of $10 billion per month may seem relatively minor, the 12-month ramp up to $50 billion per month quickly becomes meaningful, especially the $30 billion in reduced Treasury purchases. The latter figure compares with recent U.S. Treasury 10-year auctions that have averaged $21 billion per month. The seven-year and five-year auctions have averaged $28 billion and $34 billion, respectively. Although the Fed’s purchases are in the secondary market, not at Treasury auctions, assuming the Fed maintains a Treasury portfolio with about 40% in securities above five-year maturities, the absence of the Fed’s purchasing power seems likely to have some impact on five- to 10-year yields. The securities with maturities that the Fed currently purchases will have to be purchased by other investors, most likely at higher yields. Such impact could be dampened by skewing U.S. Treasury supply toward shorter maturities, but this strategy has not been suggested by either Treasury or the Fed. A reduction in the Fed’s Treasury purchases seems likely to produce some yield-curve steepening.

Mortgage Spillover
Perhaps a more meaningful impact will be felt in the MBS market. The immediate reduction of $4 billion per month in Fed purchases may be easily absorbed, but the $20 billion monthly reduction a year later could have greater consequences. Total new issuance of agency MBS averaged $134 billion per month in 2016, according to the Securities Industry and Financial Markets Association. 

The absence of the Fed’s $20 billion per month in purchasing power—equivalent to 15% of recent new issue supply—could produce some yield-spread widening between agency MBS and U.S. Treasuries of comparable maturity. An increase in MBS yields would likely pull mortgage rates higher as well, weighing on the U.S. housing sector in the process.

Thus, although the Fed’s initial pace of balance-sheet slimming seems very manageable, the prospect of persistent increases in the rate of reduction could at some point produce investor concern. That concern could be mitigated by other factors affecting yields on Treasuries and MBS, or it could happen rapidly in the form of a “tightening tantrum,” pressuring bond prices lower and yields higher. Regardless of investor reaction, the normalization of the Fed’s balance sheet seems likely to be “noisier” than the uneventful outcome suggested by Fed officials, and potentially a much different experience than the “like watching paint dry” comparison offered by Chairwoman Yellen.

Watching October
Developments on the economic, political, and market fronts during October also may contribute to market volatility and investor reaction. U.S. congressional debate on federal debt limits could increase investor angst, as well as a decision at that time by the European Central Bank to reduce its own level of quantitative easing. Increases in announced inflation by that time also could boost the likelihood of a Fed rate hike in December. As of August 18, fed funds futures data from Bloomberg suggested that investors saw only a 37% probability of a hike. 

And, finally, U.S. equity valuations also may play a role in investor reaction. To the extent investors believe that equity valuations have been fueled by years of quantitative easing, while yields have been pushed to artificially low levels, it may be difficult to persuade investors that the opposite policy—quantitative tightening—will have no meaningful market impact. Given the size of eventual balance-sheet reduction and potentially volatile environment at the time the Fed’s normalization is expected to launch, it is not unreasonable, at least in our view, to expect that the central bank’s efforts to reduce the pace of security purchases may differ from Yellen’s hopeful characterization of a process “that runs quietly in the background.”

 

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