Central banks giveth and taketh away: Bond markets prepare for a wind-down
July 27, 2017
- As the US Federal Reserve and the European Central Bank (ECB) signal a pivot toward tighter monetary policy, markets are girding for potential moves in bond prices, interest rates, and currency markets.
- The 10-year Treasury yield is a benchmark for global interest rates, so we believe a big rise would crimp financial conditions substantially.
- The ECB’s bond-buying program has had a large effect on bond markets, so a hasty unwinding could potentially result in a sharp selloff.
- The Fed and the ECB, wishing to avoid undue stress on financial markets, have indicated their intent to proceed slowly and cautiously with their tapering efforts. But questions about timing remain unanswered.
The appeal of aggressive monetary policy is that it can potentially stimulate economies under duress. That premise led central banks around the world to implement unprecedented levels of unorthodox monetary easing following the global financial crisis of 2008–2009. This loose monetary environment drove yields to historic lows and led investors on a global hunt for income. Now, some central bankers are deciding when and how to taper their easing programs. Their decisions could have implications for asset prices, interest rates, and currency markets, but the key question facing investors is: How much pressure could bond markets feel as the policy programs wind down?
We look at the issue from the perspectives of the ECB and the Fed, which are in the midst of policy moves to tighten monetary policy. Both banks are also in the spotlight for the timing of their policy wind-downs and the speed at which they plan to pursue them.
In Europe, a patient central bank, but for how long?
As the European economy continues to show slow-but-steady signs of economic strengthening, including better readings on unemployment and gross domestic product (GDP) growth, the ECB has made clear its inclination toward tighter monetary policy. In our view, the ECB will likely begin reducing monetary accommodation gradually over the coming quarters, as the cyclical economic uptick in Europe broadens. Currently, the central bank’s policy deposit rate is still in negative territory, and the bank continues its heavy purchases of 60 billion euros' worth of bonds a month, a rate that it intends to maintain at least until the end of 2017.
We believe the ECB will end bond purchases first, with any raise in the deposit rate likely coming much further down the road. This approach makes sense in our view, because we don’t see Europe’s economic profile as robust enough to warrant an immediate increase in rates. For instance, we have some reservations about Europe’s level of inflation. While it’s ticking up, inflation does not yet look convincing, and relatively low readings might continue if energy prices continue their recent spate of softening.
We anticipate that purchases could decrease by approximately 10 billion to 20 billion euros when conditions allow, although we note that the length of the purchase program will probably be extended each time. In this way, we believe, the ECB won’t shock markets by withdrawing stimulus too fast. With a gradual and well-communicated reduction, policy makers can avoid provoking a repeat of the so-called taper tantrum that shook US markets in 2013.
Yields likely to nudge upward
In our view, the gradual reduction in bond purchases should place mild upward pressure on yield spreads, as might be expected when such a large buyer gives way (see box below). It’s also important to keep in mind the rise in European corporate bond markets since the launch of the easing program, which strengthens the case for spreads to move. (One problem that corporate bonds face is their strong performance, and Chart 1 shows how low yields have become. Such strong performance suggests that spreads may widen if the ECB tapers faster than expected.) Ultimately, we think it’s reasonable to argue that German 10-year yields could rise to somewhere between 60 and 80 basis points, up from today’s reading of approximately 30 basis points. While not dramatic, it’s enough for us to reduce our exposure to European duration.
Chart 1: With the ECB’s technical support, yields are tethered
Bonds continue to find a strong bid via the ECB’s program, and yields have been anchored below 1.5% for at least a year.
Data: Barclays, depicting historical yield to worst within the corporate component of the Bloomberg Barclays Pan-European Aggregate Index. Weekly observations, through July 14, 2017.
The ECB’s outsized role: It’s technical
The ECB has been the dominant figure in European credit markets in the past year. From June 2016 (when the bond purchases began) to March 2017, the bank’s purchases of high grade, euro-denominated debt amounted to approximately 94% of the total bond issuance that was eligible for the purchase program. We believe this level of technical support — and its eventual removal — is reason to tread cautiously.
Data: Citigroup, via Dow Jones, as of April 2017.
In the US, a gradual and steady approach
In contrast with the ECB’s approach, the Fed has been more vocal in its support of raising rates if conditions warrant it, and indeed it has imposed four hikes since December 2016. Analysts agree that the rate increases have been mild, given the Fed’s commitment to a slow and deliberate path toward tighter policy.
Fed policy makers have also made clear their intention to begin unwinding the bank’s balance sheet by reducing the amount of securities that are reinvested upon maturity. Analysts expect the reduction to begin as early as the fourth quarter of 2017, though the Fed has not committed to a specific timeline.
The Fed’s $4.2 trillion balance sheet (see Chart 2) mainly consists of US Treasury securities and agency mortgage-backed securities, to the tune of $2.4 trillion and $1.8 trillion, respectively. The following discussion will focus on the role of US Treasurys.
Chart 2: Growth of the Fed’s balance sheet
Data: Federal Reserve Bank of New York, through July 12, 2017. Weekly observations.
Toward a new normal?
At the conclusion of its June 2017 meeting, the Fed’s policy-setting committee officially spelled out its plan for reducing the size of the bank’s security holdings. We believe that the committee, like the ECB, does not want a repeat of the 2013 taper tantrum and thus has been broadcasting its plans for balance-sheet normalization well in advance.
Given the current economic outlook, the Fed anticipates it will begin reducing its balance sheet when the federal funds rate reaches a range of between 1.25% and 1.50% (which will be the case after one more rate hike). We believe that even if the fed funds rate remains below that level, the Fed will likely look to begin reductions by the end of 2017.
In an effort to limit negative market ramifications, the Fed does not plan to stop reinvestments altogether, but will simply reduce the amount being reinvested.
Given the current maturity profile of the Fed’s Treasury portfolio, a large portion will mature in 2018 and 2019. As shown in Chart 3, securities amounting to $425 billion are scheduled to mature in 2018, followed by $357 billion in 2019. Maturity buckets of this size necessitate a gradual approach in which a set amount of proceeds is allowed to run off each month, while anything above that amount continues to be reinvested.
Accordingly, the Fed’s stated plan will start by decreasing reinvestments by $6 billion per month, to be reduced by an additional $6 billion every three months over a period of 12 months, until the reduction reaches a desired rate of $30 billion per month. Meanwhile, the mortgage-backed securities portion of the Fed’s holdings will start at reductions of $4 billion and follow a similar schedule until hitting a cap of $20 billion, for a program-wide total reduction of $50 billion per month.
If the Fed begins the program in December 2017, it should reach its desired balance sheet* at some point in mid-2020 or early 2021. Of course, the bank retains the flexibility to alter its plan should US economic conditions deteriorate.
Chart 3: Dollar value of US Treasurys due to mature, by year
Data: Federal Reserve Bank of New York, as of May 1, 2017
Possible extent of market impact
The process the Fed uses to reinvest its maturing Treasurys can seem somewhat opaque. Instead of placing outright purchase orders, here is what the Fed does: As the bonds mature, it adds the proceeds to the total batch of upcoming Treasury auctions, thereby reducing the amount of securities that need to be auctioned to the public. By the same token, a reduction in reinvestments requires the Treasury Department to increase the amount it auctions to the public. In theory, the net effect of the latter is that the increased supply of Treasury bonds puts upward pressure on yields.
But how big of an effect can we expect of the smaller reinvestments? In 2010, the Federal Reserve Bank of New York estimated that $500 billion of purchases would translate to a 0.50 to 0.75 percentage point cut to the federal funds rate. Using the inverse of this calculation as a guide, we estimate that the normalization process could eventually nudge rates upward by 1.25 to 1.75 percentage points. These data suggest that the risk of a big jump in yields is low, and we believe it should play out that way, given the Fed’s intent to pursue a slow and cautious approach to winding down its balance sheet.
Amid possible dissonance, several factors to watch
While the Fed is moving toward policy normalization, we also know that the US economy continues to exhibit slow growth and relatively low inflation. This apparent discord raises the question of just how much tightening the economy can handle. Our view is that today’s economic environment is likely to persist and could possibly frustrate the Fed’s plans. Already, this friction is being reflected in the difference between the Fed’s stated goals and what the market is projecting: The Fed’s so-called “dot plot,” which shows interest-rate expectations across all members of its policy-setting committee, calls for a federal funds rate of 3% at the end of 2019, while the market is currently pricing in a rate of less than 2%.
We can sort our concerns into two broad categories:
- Global monetary policy. It will be important to monitor developments in global monetary policy, because the Fed is currently alone among major central banks in reducing liquidity. Other banks, like the Bank of England and the Bank of Japan, continue to inject liquidity into their respective economies. This divergence could have implications that reach beyond government debt markets, possibly affecting currency markets, international fund flows, and generally perpetuating an asymmetrical global economic recovery in which some countries and financial markets are more resilient than others.
- Risk markets. It will be equally important to watch risk markets, which have enjoyed steady central bank support since the financial crisis. As that support wanes, it could result in downward pressure on prices for these assets.
*The Fed has not formally specified a target size, but many analysts — and at least one Fed governor — estimate that it will be north of $2 trillion.
The Bloomberg Barclays Pan-European Aggregate Index measures the performance of investment grade securities issued across the entire European continent, including Treasury, government-related, corporate, and securitized fixed-rate bonds.
Yield to worst is a measure of a bond’s yield that assumes the worst-case scenario; that is, it assumes that the bond is retired on the earliest possible redemption date, as specified in the bond’s formal documentation.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The views expressed represent the Manager's assessment of the market environment as of July 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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