The End Of Quantitative Easing: Implications For Fixed-Income Markets

06.27.17
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SUMMARY AND MAJOR CONCLUSIONS
  • The purpose of this analysis is to explore the potential implications for financial markets as the Federal Reserve begins to unwind its inflated balance sheet later this year. As the Federal Reserve gradually suspends re-investment of proceeds from maturing bonds, supply and demand in credit markets will be altered, with potential ramifications for long-term interest rates.

  • Shrinkage of the Federal Reserve’s balance sheet — essentially a systematic unwinding of quantitative easing (QE) — will be implemented gradually and at a measured pace over many years. As a result, the impact on yields in the U.S. Treasury market will be minimal (potential increase of 50 bps).   

  • In the immediate aftermath of the financial meltdown in 2008, the Federal Reserve under Ben Bernanke adopted and implemented the most aggressive and unorthodox set of policies in the 100-year history of the Federal Reserve System.

  • The most radical policy tool adopted was QE, whereby the Federal Reserve intervened directly and aggressively in the government bond market to purchase bonds from the banking and non-banking public. The Fed’s balance sheet surged from less than $1.0 trillion in 2008 to $4.5 trillion currently.

  • The purpose of QE was threefold: To inject massive amounts of liquidity into the financial system; to stabilize the banking sector and to spur a resumption of bank lending; and to lower market interest rates on long-dated fixed-income securities.

  • The working assumption is that the Fed will begin to shrink its portfolio by the end of this year or, at the latest, early 2018. The Fed will accomplish its mission by passively allowing maturing bonds to naturally roll off its portfolio without re-investment of principal, as opposed to outright sales of government bond holdings.  

  • Restoring the Fed’s balance sheet to normal will almost certainly exceed five years and could require up to ten years. It is also conceivable that the Fed will stop short of reducing its portfolio to pre-crisis levels.

  • It is reasonable to assume that the Federal Reserve will be extremely cautious and sensitive to economic and financial conditions and will meticulously shrink its balance sheet at a measured pace to minimize any disruption, dislocation or turbulence in financial markets.

  • In addition, it is highly likely that new debt issuance by the Treasury Department in coming years will be heavily tilted toward short-term U.S. Treasury bills, rather than longer-dated securities, thereby alleviating pressure on yields of long-term bonds.

  • There is no change in the expectation for steadily rising bond yields in coming years, but this forecast is predicated upon assumptions regarding traditional economic factors — economic growth, inflation and the Federal Open Market Committee’s (FOMC) conventional rate-tightening cycle — rather than the expected unwinding of QE. The unwinding of QE is likely to make only a minor contribution to the expected upward path in yields.

CAPSULE SUMMARY

There is spreading concern among investors regarding the inevitable shrinking of the Federal Reserve’s artificially bloated balance sheet, expected later this year or early next year. The conclusion of the analysis is that the gradual downsizing of the Federal Reserve’s holdings of government bonds will have some impact on market prices and yields for Treasuries, Mortgage-backed Securities (MBS) and agency bonds, but almost certainly far less than generally feared. A negative psychological knee-jerk reaction by bond investors as the unwinding program is announced and implemented cannot be ruled out, but the impact is likely to be transitory.

Offsetting actions by the FOMC and Treasury Department should alleviate the initial upward pressures on yields in the U.S. Treasury market, while the Fed gradually retrenches as a major buyer of bonds, through re-investing proceeds of maturing bonds. The fixed-income market sector at greatest risk is MBS — because of the Fed’s overwhelming presence in this market — with obvious spillover effects to borrowing costs on long-term, fixed-rate mortgage loans.

Bond issuance has surged over the past year in response to optimal credit conditions, which in turn have benefitted from depressed yields on government bonds and tightening spreads on corporate debt. However, a marked shift in market conditions appears likely over the next six to twelve months, as late-cycle pressures begin to intensify. A combination of accelerating economic growth, rising inflationary expectations, continuation of the current rate-tightening cycle, the potential for a sudden rise in default rates, widening credit spreads and the onset of a reversal of QE should all conspire to exert upward pressure on corporate bond yields, which are likely to intensify in the years beyond 2018. The implication is that domestic companies should have a unique window of opportunity to lock in historically depressed long-term borrowing costs.

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