Fed Watch: Moving On…and Rather Quickly

kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
11/03/2021

The Fed’s announcement to begin tapering its balance sheet was a well-telegraphed development that, in and of itself, should not really have any meaningful impact on the money and bond markets. Sure, the actual implementation of scaling back its asset purchases could potentially impact U.S. Treasury (UST) and mortgage-backed securities (MBS) valuations, but it appears as if the policymakers succeeded with its “forward guidance” on this front, and the focus has already turned to the next phase of the exit strategy: rate hikes.

Back to the Fed balance sheet for a moment to get some perspective on this pandemic-related round of quantitative easing (QE). As a reminder, the Fed’s balance sheet is actually made up of more than just its UST and MBS holdings, and the actual component where QE shows up is its System Open Market Account, or SOMA. During this QE4 operation, the Fed added more than $4.1 trillion to its UST and MBS holdings, more than doubling SOMA to $8.0 trillion. This was an enormous addition to the Fed’s balance sheet and compares to total QE purchases of $3.25 trillion during the financial crisis-related tranches of QE.

One final note on tapering before I turn to rate hikes. Keep in mind that the policymakers are reducing the size of future asset purchases, it is not ending them. Thus, QE4 is still alive and well; it is just operating at a scaled-back pace. If history is any guide, even when the Fed ends new purchases of UST and MBS, it will more than likely reinvest any maturing proceeds from its holdings, keeping SOMA flat at an elevated level, accordingly.

On to rate hikes! Readers of my blog are fully aware that this aspect of the Fed’s exit strategy is the one I’ve been focusing on quite a bit. I’m not alone. Not only has the 2–5-year sector of the UST market begun pricing in “liftoff,” but the Fed Funds Futures arena has made a visible shift in this direction as well. In fact, the implied probability analysis factored in not just one rate hike for 2022, but two and a half increases. I know there’s no such thing as half of a Fed Funds increase, but I think you get the picture here—i.e., there is a growing perception the Fed may implement more than two rate hikes next year. In addition, the timing for the “liftoff” has been pushed up to next July. 

Conclusion

As much as Chair Powell appears to be trying to de-link, if not outright downplay, rate hikes, the collective market, thus far anyway, hasn’t been listening. It kind of reminds me of the whole “inflation is transitory” argument to some extent, which, by the way, the Fed seems to be reluctantly admitting could mean up to a year, not just a month or two. Looking ahead, the bottom-line message is that monetary policy is likely embarking on the process of turning from a tailwind to a potential headwind for bond portfolios…plan accordingly!

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About the Contributor
kevin-temp2
Head of Fixed Income Strategy
Follow Kevin Flanagan
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.