Key Takeaways

  • We expect the Fed to announce asset reduction in September.
  • This may push 10-year Treasury yields higher over time.
  • We estimate that impact could be 20 to 40 basis points.
  • However, long-term yields should remain anchored.

The Federal Reserve employed numerous tools in response to the 2008 financial crisis. With its policy normalization underway, its next move could be the most important yet. It will soon begin shrinking its balance sheet, allowing longer term yields to drift higher.

How This Move May Affect Markets

The Federal Reserve is widely expected to begin reducing its balance sheet over the next few months. This marks a major policy change that could impact interest rates and markets more broadly.

Long-term interest rates could move higher over the medium-term as the Fed starts to shrink its asset holdings. However, the magnitude of the rise may be modest. Our fixed income interest rates team estimates the impact on 10-year Treasury yields could be 20 to 40 basis points over time, which is consistent with projections provided by the Treasury Borrowing Advisory Committee. This estimate is based on the assumption that the broader macroeconomic environment will not shift significantly.

Although higher yields impact bond prices, significant losses can be avoided by most fixed income investors, particularly those who rely on managed bond funds that can benefit from reinvesting in higher yielding securities, as well as from duration management.

In any case, rate normalization is well underway, with the Fed having raised its policy rate four times since late 2015. This has boosted the Federal Funds rate to a range of between 1.00 and 1.25%. Nevertheless, 10-year Treasury yields have remained mostly in the range of between 1.40% and 2.60% over this period and were hovering around 2.25% at the end of August. Given relatively tame inflation and a modestly growing economy, we expect long-term interest rates to remain range-bound.

The Federal Reserve Balance Sheet

When Will the Fed Begin Its Program?

In the Fed’s June 2017 meeting, it outlined its intention to gradually taper, or reduce, the reinvestment of principal payments from maturing securities. Its July meeting minutes indicated that monetary policymakers were ready to begin this program “relatively soon.” This and other clues lead us to believe that it will announce in its September meeting that balance sheet reduction will begin on October 1, 2017. Once initiated, we anticipate tapering will operate in the background on auto-pilot as outlined by the Fed provided there are no major shocks to the economic recovery.

Mortgage-backed securities may be vulnerable to the Fed tapering. Although MBS have already felt some impact given tapering expectations, and having cheapened earlier this year against Treasuries, additional uncertainty on the impact of reduced Fed purchases could weigh on this sector.

How Will the Fed Reduce its Balance Sheet?

The Fed will structure this reduction by capping the amount of proceeds it reinvests from maturing securities, starting at $10 billion per month, with a 60-40 split of Treasuries and mortgage-backed securities, and gradually increasing the cap over the year to a total of $50 billion. That terminal principal reinvestment reduction will remain in place until the size of the balance sheet is normalized. While unlikely to fall all the way back to its pre-crisis size of $1 trillion, we expect the balance sheet to normalize at around $3.3 trillion from a high of over $4.5 trillion.

This policy change represents a major step for the Fed. However, with a potentially modest impact on rates over time, investors in well-managed bond funds shouldn’t feel a dramatic impact.

How the Federal Reserve's Balance Sheet Tapering Plan Will Work

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