QE: The beginning of the end

The Fed officially announces its historic plan to reduce its balance sheet

Sep 20, 2017 | James Ong, Brian Schneider and Clint Dudley

Today, the Federal Reserve (Fed) officially announced the start of its balance sheet unwinding process, embarking on a slow journey of reversing the quantitative easing (QE) policy that it launched in the wake of the global financial crisis. This means the Fed will soon start shrinking its $4.5 trillion1 bond portfolio to a level it deems optimal based on future economic conditions. The mechanics of the program are in line with plans laid out at the June Fed meeting and, along with the broader announcement, were widely anticipated by the bond market.

What did the Fed announce?

Starting in October, the Fed will stop reinvesting in bonds once they mature. As bonds mature and proceeds are not reinvested, the Fed’s balance sheet will shrink. The monthly balance sheet reduction will be capped at $4 billion of mortgage-backed securities and $6 billion of Treasury securities. These caps will increase quarterly until they reach a maximum of $50 billion combined per month.2

The Fed also released its latest Summary of Economic Projections (SEP). The SEP is the Fed’s forecast of key economic variables like growth and inflation, and it is watched closely for clues on the Fed’s economic view and the likelihood of future rate hikes. The Fed reduced its inflation and growth forecasts slightly; however, those declines mostly reflected disappointments in inflation since the June meeting and the impact of two devastating hurricanes. Going forward, inflation will be in the spotlight since inflation data have consistently come in below expectations (and the Fed’s 2% target), but ticked up in August, raising the likelihood of a December rate hike.

Another important barometer of the Fed’s economic outlook is the so-called “dot plot,” which charts Fed committee members’ forecasts of future interest rates. The dots suggested that the expected near-term pace of tightening remains largely unchanged, with a hike anticipated in December and three more in 2018. However, these forecasts have become less relevant since several current Fed members are set to retire and some new members added, which will make future dot comparisons difficult as new views are incorporated.

What will the market impact be?

The release of this information caused Treasury prices to decline. Invesco Fixed Income believes the market had not expected the SEP to indicate a rate hike in December and three in 2018, since inflation has been surprisingly low and certain members had conveyed a more dovish stance, especially following Hurricanes Harvey and Irma.

In the medium term as the caps increase, bond markets are faced with absorbing the ongoing supply of Treasury and mortgage-backed security issuance on their own — without the backstop of the Fed. All else equal, we expect this new supply-demand dynamic to pressure bond yields higher, making yield curves steeper and spreads on mortgage-backed securities wider.

In the mortgage market, balance sheet tapering will likely have a minimal impact on mortgage valuations initially, but is expected to become more impactful in 2018, as the private market gradually absorbs a greater supply of mortgage-backed securities. So far, the Fed’s transparency regarding its plans for tapering has been a significant factor in keeping market volatility low. Assuming this continues, the yield premium on mortgage-backed securities relative to Treasuries should offset much of the negative impact caused by increased supply, in our view. In addition, we believe there is a limit to how much mortgage spreads can widen since any material cheapening in mortgages would likely trigger a reallocation away from more fully valued assets, such as high-grade corporate bonds, into mortgage-backed securities. Similar to the mortgage market, we expect the initial phase of balance sheet reduction to have a minimal effect on Treasury prices. The taper announcement has been well-telegraphed, and the Treasury market should be able to absorb an extra $6 billion of Treasury bond supply, in our view. However, as caps move higher, Treasury prices may have a harder time staying stable. We expect this to be an issue starting in 2018. Higher long-term Treasury yields may cause financial conditions to tighten. Tighter financial conditions may cause the Fed to hike rates more slowly.

However, there are many moving pieces to this puzzle. Two additional elements factor into the potential impact of today’s announcement on bond markets in the medium term: potential actions of other global central banks and the Fed’s reaction to future inflation information.

  • Like the Fed, global central banks, such as the European Central Bank, are likely to begin tapering their QE purchases soon as their economies gather steam. The Bank of Canada and the Bank of England have already begun or indicated they will start tightening monetary policy. The combination of global central bank tapering and tightening actions may cause additional yield volatility going forward.
  • In the US, the Fed’s reaction to incoming inflation data will likely also be critical. The Fed has indicated that improving inflation dynamics are necessary for further interest rate hikes. The next few months of inflation data will be helpful in determining if inflation is returning to trend and, therefore, the likely path of interest rates. We believe that inflation will continue to slowly improve over the next several months and will likely justify a December Fed hike.
     

What could go wrong?

As we have written in previous blogs, the main risks to our view revolve around the possibility of a “policy mistake.” In other words, if the Fed overreacts to future signs of inflation, it could cause bond markets to price in disinflation. This could have the effect of driving interest rates lower.

This type of disinflationary policy can also cause risky assets to sell off. A combination of higher short-term interest rates and greater interest rate volatility may be enough to slow down the pace of growth.

 

1 Source: Federal Reserve Bank of New York, as of Sept. 13, 2017
2 Source: Federal Reserve, as of Sept. 20, 2017