Life Was Simpler for Bond Traders in Past Fed Hikes
The minutes of the Federal Reserve's March 14-15 policy meeting kept alive the notion, or at least the central bank's notion, that three more interest-rate increases are on tap before the year is out. The market disagrees, and for good reasons. Some are economic -- awful auto sales, for example -- and some are more technical, namely the interplay between rate hikes and the reduction in the size of the Fed’s $4.47 trillion balance sheet.
This interplay is a huge uncertainty that makes this hiking cycle different from all others that have come before it. In the past, the Fed raised the federal funds target rate and bond traders would respond accordingly. The result was a predictable bear market that pushed up yields on short term bonds at a faster rate than those on longer maturities. That would cause the yield curve to flatten to the point where it started to look like it would invert, which usually presaged a recession. That would also be the point when longer-term bonds became attractive. Life was simpler then for bond traders.
Now, there's a new paradigm on the horizon. While the Fed has gingerly started hiking, the minutes released last week show that most policy makers agree that later this year will be an ideal time to begin trimming the balance sheet, which grew from less than $1 trillion in 2008 to more than $4 trillion today after three bouts of bond purchases and reinvesting redemptions. Bringing the balance sheet into the mix creates an uncertain challenge to both ends of the yield curve. When the Fed stops reinvesting the proceeds from maturing securities into new bonds, it will be up to the market to fill the void. Of the $4.2 trillion of bonds held by the Fed, about $2.4 trillion have maturities of 10 years or more. Thus, there will added supply on the long end of the curve, which will result in higher yield premiums to induce buyers.
This will happen at a time when the federal budget deficit is forecast to expand, which will mean more issuance of coupon-bearing Treasuries by the government. When the Congressional Budget Office updated its long-term budget outlook at the end of March, it boosted its deficit forecasts into 2026 by $633 billion as a result of “the budgetary laws enacted by 114th Congress.” That doesn’t even account for any added shortfalls that might result from lower taxes or more fiscal spending under the Trump administration. Nor does it anticipate any recession, which would have a deleterious impact on impact on the budget.
Is there a scenario under which a tightening cycle would create a steeper yield curve? It’s possible. Consider that New York Federal Reserve President Bill Dudley recently said that “if and when we decide to normalize the balance sheet, we might actually decide at the same time to take a little pause in terms of raising interest rates.”Given the already slow pace expected by the market in this particular cycle, any further slowing would be a big deal and, relatively speaking, allow the front end of the curve to outperform the back-end. Needless to say, the timing and magnitude will prove the determining factors in the curve behavior.
Given that, I have four nearish-term scenarios in mind:
- The Fed hikes more or less on schedule (meaning the market’s schedule) and announces a tapering in the reinvestment program. I’d expect a formal announcement in the fourth quarter with ample warning well beforehand. Here the curve impact should initially be neutral, but the market is put on notice and the past of least resistance will ultimately be a steeper curve. I’d wager 75 percent odds in favor of this happening.
- The Fed chooses to stop reinvesting immediately -- again, a fourth-quarter announcement for implementation in 2018. This would be bearish for the back-end of the yield curve (as well as mortgage-backed securities) but offers some consolation to the front in the form of gradualism. In other words, the hint is that policy makers err on a slower pace of hikes. This causes the yield curve to steepen, but I'd put lower odds on this scenario, maybe 15 percent.
- The Fed sells securities outright. I would say not in my lifetime, but perhaps not in the lifetime of my career, which is hopefully shorter than the former. Again, the Fed’s selling would coincide with a rising federal budget deficit, and any resulting rise in long-term yields would presumably hit the economy hard. I just don’t see this happening for years, and put the odds at 5 percent.
- The Fed does nothing or actually adds to its balance sheet. Having opened up the Pandora’s Box of the balance sheet in the last recession, it’s now become a tool for the next one. I’d give this low odds -- I only have 5 percent left to play with -- though I do think a recession is a reasonable bet before the next presidential election if only due to the longevity of the current expansion.
Among the imponderables faced by the markets is the future makeup of the Fed. Will they be businessmen who favor easy money along the lines of the "Free Silver" populists of a past era, or the anti-Yellens of Trump’s campaign rhetoric? The best I can offer on that is a dose of added volatility to mix.
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