By Dan Denbow, CFA, Senior Portfolio Manager of Equity Investments
Investors hoping for a surprise out of this week’s Federal Reserve meeting are not going home entirely disappointed.
As anticipated, the Fed voted to raise short-term interest rates by another quarter-point, to a range of 1% to 1.25%. This latest rate increase is the fourth in a slow tightening trend that began in December 2015.
And as assumed, the Fed’s post-meeting statement keeps open the possibility of at least one more rate hike in 2017, provided the U.S. economy’s performance doesn’t jump the tracks.
But the policymakers did catch the market a little off-guard by serving up a larger-than-expected ration of details as to how it intends to start paring back the $4.5 trillion worth of bonds it’s now holding on its balance sheet. They were vague on timing, however, saying only that they planned to start sometime this year.
Asset markets had long priced in a June rate hike – in our view, this allowed the Fed to act on its desire to gradually nudge rates higher without fear of creating a disruption. If it had defied expectation by putting off a rate bump this week, investors might have been spooked by the idea that the Fed knew something big that markets hadn’t priced in.
While the Fed is now planning for at least one more rate increase this year, it’s possible that could change if U.S. economic data continues to come in on the fair-to-weak side.
On the plus side, the unemployment rate is at its lowest in a decade, wage growth is picking up and consumer optimism is running high. But the New York Fed’s GDP growth forecasts for the second and third quarters are in retreat (following a disappointing 1Q) and consumer inflation has been in steady decline since February – in May, it fell below the Fed’s 2% annual target for the first time since last November. Worries about the economy and potential policy missteps are reflected in the 10-year Treasury yield, which this week dipped to its lowest level of 2017.
On the Fed’s balance-sheet reduction plan, we had been concerned that it would be too aggressive in trimming back the trillions of dollars in bonds it holds. Most of these securities were purchased as part of the Fed’s “quantitative easing” program aimed at driving down borrowing costs and spurring economic activity following the 2007-08 financial crisis.
At first blush, it appears that the Fed is showing a bit of restraint in how it intends to carry out its balance-sheet runoff. It will start by letting $10 billion worth of bonds (a combination of Treasuries and mortgage-backed securities) mature each month, and each quarter it will gradually widen the runoff as conditions warrant until eventually reaching a maximum of $50 billion per month.
Moving too quickly would have risked a drop in bond prices at the long end of the curve and a corresponding spike in bond yields – yields rise as prices fall.
The Fed hasn’t been adding to its net bond holdings since ending QE in 2014, but it has still been a major player in the Treasury and MBS markets by reinvesting the principal from maturing bonds to maintain a constant position. By allowing even a slow runoff, the Fed will be less of a buyer in those markets, which could push down prices and push up interest rates.
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