At its March 15th meeting, the Federal Reserve (Fed) decided to raise the federal funds rate target to 0.75%-1.00% – the third such increase since the Fed started tightening monetary policy in December 2015. As the move was widely anticipated, markets had little reaction. Two more rate increases are expected this year.
Lost in the Fed’s decision are two other things which will make “Fed watching” a more active sport going forward than it’s been in quite some time. After all, for several years while short-term interest rates remained near zero, “Fed watching” was as interesting as that other popular spectator sport – watching paint dry.
Unwinding Quantitative Easing (QE)
Following the financial crisis, the Fed engaged in three rounds of QE aimed at further stimulating the U.S. economy after short-term interest rates had been lowered to zero. This involved the Fed purchasing long-term U.S. Treasury bonds and mortgage-backed securities. As a result, the Fed’s balance sheet grew from $1 trillion before the crisis to $4.5 trillion by the time QE ended in late-2014.
Until now, the Fed made no mention of how it intends to unwind its massive balance sheet. The bonds could simply mature and the proceeds not reinvested. This could take years and be uneven at best given the varying maturities of the bonds in the Fed’s portfolio. Or, the bonds could be sold to the public. Either way, unwinding QE will be a giant undertaking which will likely have an impact on interest rates.
In its March meeting minutes, the Fed said it will consider stopping reinvestment but gave no timeframe for doing so. Many think this will be formally announced later this year and the unwinding will begin in 2018. As its uncharted territory, how the Fed approaches this monumental task and how it communicates its plan to the market will be something worth watching in the months to come.
Flattening Yield Curve
After three rate increases, short-term interest rates now sit between 0.75% and 1.00%. One might expect longer-term rates to rise in lock-step. However, even with the recent hikes in December and March, the 10-year Treasury yield has fallen slightly since the start of 2017. Why is this?
Remember that long-term rates essentially represent an expectation of where investors think short-term rates will be in the future. The Fed’s objective in raising rates now is to prevent the economy from over-heating and to keep inflation in check. If the Fed overshoots, the U.S. economy could slow down too quickly or go into recession.
Often, when the Fed raises rates, yields further out on the yield curve don’t increase at the same pace causing the yield curve to flatten. A flatter yield curve can also be a signal of an impending recession although recent data doesn’t indicate the economy is on the verge of a slowdown. Also, when the Fed starts unwinding its balance sheet as previously discussed, longer-term yields may rise, causing the yield curve to regain its upward slope.
What does all of this mean for your bond portfolio? The revival of “Fed watching” is again a reminder that the bond market is not the same as it used to be. With rates moving, QE unwinding, and the likelihood of unforeseen events, diversification within bonds is just as important as within stocks. And, it’s important to strike a balance between the quest for returns and defense against rising rates. Today, with the proactive adjustments already made to your bonds in 2016, these risks have been balanced out.