Fixed Income: Finding the Right Balance
In the post-Federal Reserve (Fed)-meeting world of the money and bond markets, there seems to be a disconnect between what market participants are thinking and the Fed policy decisions that are actually being made. It is a case of the market not buying what the Fed is selling. In other words, the term “policy mistake” has begun to enter the discussion, as the U.S. Treasury (UST) arena appears to be operating under the assumption that the Fed should perhaps ease up on its tightening campaign because (a) inflation has been slowing in recent months, and (b) economic growth has been lackluster. This line of reasoning concludes that the policy makers will go too far with their rate hike and balance sheet normalization plans, to the detriment of the economic setting.
Based on the Fed’s actions at last week’s June FOMC meeting, the policy makers do not seem to be deterred in their “full steam ahead” outlook, as they envision yet another rate hike this year and expect “to begin implementing a balance sheet normalization program this year” as well. So, let’s assume economic and financial conditions do live up to the Fed’s expectations, what then will their plan look like for phasing out their reinvestment program?
Fed's Balance Sheet Normalization Guidelines (in billions)
Going into this year, we anticipated the Fed taking the next step in its policy normalization process, addressing the reinvestment of Treasury holdings, agency debt and MBS. However, much like the policy makers moved up the timing of the first rate hike in 2017, the timetable for the balance sheet part of the equation has also been expedited. Although the voting members did not specifically lay out a date for the announcement and implementation of phasing out these reinvestments, if the Fed holds to the script it has followed thus far, an announcement at the September FOMC meeting is certainly a distinct possibility. In fact, at the June FOMC presser, Chair Yellen mentioned how the balance sheet plan could be put into effect “relatively soon.”
Along these same lines, the Fed has now provided specific dollar amounts and a timetable of sorts. As you can see in the enclosed table, the initial phase will consist of a $6.0 billion cap on reductions in Treasuries and $4.0 billion on the mortgage backed securities front. Subject to conditions, the plan would then be to increase the amount of paydowns by $6.0 billion in Treasuries and by $4.0 billion in MBS every three months until a peak of $30.0 billion is reached for UST and $20.0 billion for MBS. This translates into a combined drawdown of $10.0 billion to start and potentially $50.0 billion a year later. In theory, if the $50.0 threshold is attained, the combined reduction in the balance sheet would amount to $600 billion over a 12-month period. To put this into some perspective: as of this writing, the Fed’s holdings of Treasuries, agency debt and MBS came in at $4.26 trillion.
By making its balance sheet plan process public this quickly, the Fed is trying to make the actual implementation of the plan go as seamlessly as possible. The goal would be to have the bond markets essentially immune to any potential dislocations as the phase-out of reinvestments would be viewed as just another background type of event. Keep in mind that once the process begins, the bond market will be entering new territory, though.
Unless otherwise noted, data source is Federal Reserve, as of 6/14/2017.
Important Risks Related to this ArticleFixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.