Wall Street’s Bond Gurus Have the Fed’s Balance-Sheet Unwind All WrongBy
During periods of central-bank purchases, Treasury yields rose
Fed likely to announce start of balance-sheet runoff this week
On Wall Street, the conventional wisdom is that once the Federal Reserve finally starts to whittle down its crisis-era debt investments, U.S. Treasury yields will have nowhere to go but up.
But to some bond investors, history suggests the consensus couldn’t be more wrong.
During each of the Fed’s quantitative-easing cycles, yields rose when the central bank was buying and then fell after it stopped. That ran counter to what many expected based on simple supply and demand as the Fed amassed $4.5 trillion of debt and became the single biggest holder of Treasuries.
The lesson, investors say, is that what really matters to the bond market isn’t so much what the Fed is doing, but what the policy changes mean for the U.S. economy in the months and years ahead.
In the case of QE, the Fed’s stimulus brightened the outlook for growth and inflation, while the periods in between refocused investors on the mediocre state of the post-crisis economy. Now, as the Fed embarks on its long-awaited QE unwind, doubts about the strength of the eight-year expansion may arise once again and push investors toward the safety of fixed income.
“During QE, the important thing was the signaling effect -- the Fed was going to come in and reflate the economy, provide stimulus and higher rates of growth, and dissuade people from owning Treasuries and force them into other markets,” said Brian Nick, the chief investment strategist at TIAA Investments. “Now on the way out, if the idea is that the Fed is not as stimulative as it once was, it might have the effect of depressing” bond yields.
While the Fed has lifted interest rates three times since December, 10-year yields have fallen as expectations for faster inflation and fiscal stimulus from the Trump administration proved to be short-lived. They ended at 2.23 percent on Monday. At the start of the year, they were closer to 2.5 percent.
The Big Unwind
Fed officials are expected to announce more details regarding their balance-sheet plans on Sept. 20. In June, the Fed laid out a framework for reducing its holdings. It called for letting as much as $6 billion of Treasuries and $4 billion of mortgage-backed securities run off each month, raising that cap quarterly.
In the past, the yield curve, or the gap between rates on short- and long-term Treasuries, has reliably narrowed as the Fed raised rates to cool growth. But the risk now is that the QE unwind could inundate a market that many already consider to be stretched.
The Fed’s holdings are equal to a quarter of the U.S. annual gross domestic product. That compares with around 6 percent from 1998 to 2008. What’s more, its investments to maintain the current size of its U.S. debt holdings financed roughly 40 percent of America’s budget deficit last year.
“Yields should edge higher,” said Stanley Sun, U.S. rates strategist at Nomura Holdings Inc. “As you have new supply come into the market without the Fed on the other side, that’s what’s going to weigh on the market.”
Indeed, in the most recent Bloomberg survey this month, Wall Street forecasters saw 10-year yields reaching 2.48 percent by year-end before gradually rising to exceed 3 percent in 2019. The yield fell 1 basis point to 2.22 percent at 6:13 a.m. in London Tuesday.
Ken Harris, who oversees $4.5 billion as director of fixed-income portfolio management at Denver Investments, says that scenario is unlikely to pan out.
With inflation still running below 2 percent and the economy expected to grow just 2.2 percent this year, the expansion is showing few signs of returning to pre-crisis growth levels.
“The market is hung up” on the idea the run-off will drive prices lower, Harris said. Tighter monetary policy would “actually be restrictive and tightening in the face of low inflation and modest growth. It’s another signal that the Fed is a little bit ahead of itself.”
The Fed’s pullback may even spur more foreign buying. Yields on 10-year Japanese bonds remain near zero, while those on German bunds are the least attractive versus Treasuries in almost a year.
“Yes, the Fed might release some Treasuries into the market, but the demand will be there,” said Dimitri Delis, senior econometric strategist at Piper Jaffray. “Ultimately, you have to remember we have among the highest yields in the developed world.”
In other words, take all the doomsaying from Wall Street types like Jamie Dimon with a grain of salt. It might not be as bad as most people think.