Fed’s New Normal Is Uncharted Territory For Bonds (IEF)

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September 22, 2017 6:35am NYSE:IEF

bonds market

From WisdomTree: September has certainly been the month for central banks. Indeed, investors have already witnessed formal policy meetings from the Bank of Canada (BOC), the European Central Bank (ECB) and the Bank of England (BOE).


In two out of these three convocations, the results have tilted more hawkish than consensus expectations. The BOC meeting was the first to take place this month, and the Canadian policy makers surprised the fixed income markets by implementing their second rate hike in as many meetings. The BOE did not raise rates at its gathering just last week, but intimated that an increase could very well be coming in the months ahead.

That brings us to today’s outcome of the Federal Open Market Committee (FOMC) meeting. From a headline perspective, the results did not deviate from expectations. Specifically, the voting members decided to take a break from their rate hike cycle and instead announced their widely telegraphed decision to begin the balance sheet normalization process, beginning next month.

The details behind their plan to begin phasing out their reinvestments in Treasuries and mortgage-backed securities (MBS) were already provided following the June FOMC meeting, which we highlighted in a previous blog post “Fixed Income: Finding the Right Balance.” To summarize, the initial phase will consist of a $6.0 billion cap on reductions in Treasuries, and $4.0 billion in MBS. Subject to certain conditions, the plan would then be to increase the amount of paydowns by $6.0 billion in Treasuries, and by $4.0 billion in MBS every three months until a peak of $30.0 billion is reached for UST and $20.0 billion for MBS. This translates into a combined drawdown of $10.0 billion to start and potentially $50.0 billion a year later. In theory, if the $50.0 billion threshold is attained, the combined reduction in the balance sheet would amount to $600 billion over a twelve-month period. To put this into some perspective, as of this writing, the Fed’s holding of Treasuries, agency debt and MBS came in at $4.25 trillion.

UST Maturity Distribution on Fed’s Balance Sheet (in millions)

UST Maturtity on Fed's Balance Sheet

As this September gathering had been getting closer and closer, a question I heard on a number of occasions was: What is the UST maturity distribution of the Federal Reserve’s (Fed) holdings? Before we answer that query, a couple of general notes. First, the Fed’s total holdings consist of Treasuries, MBS and federal agency debt securities. The combined portion of MBS and agency makes up 42% of the Fed’s total balance sheet holdings, essentially all of which in MBS. That leaves 58% of the overall amount for Treasuries. As the table above illustrates, nearly half of the Fed’s UST holdings lie in the “Over 1 Year to 5 Years” sector, with the next largest share (nearly 26%) in maturities of greater than 10 years. Perhaps a better way of looking at it is that maturities 5 years and under make up 61%, while the tally above the 5-year threshold is 39%.

Conclusion

By making its balance sheet plan process very open and public, the Fed was trying to make the actual implementation of the plan go as seamlessly as possible. The goal would be to have the bond markets essentially be immune to any potential dislocations as the phase out of reinvestments would be viewed as just another background event. Keep in mind, though, that once the process begins, the bond market will be entering new territory, and it could very well be occurring simultaneously with additional rate hikes.

Unless otherwise noted, data source is Federal Reserve as of 9/14/2017.


Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.


The iShares Barclays 7-10 Year Treasury Bond Fund (NYSE:IEF) was unchanged in premarket trading Friday. Year-to-date, IEF has gained 2.96%, versus a 12.60% rise in the benchmark S&P 500 index during the same period.

IEF currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #3 of 28 ETFs in the Government Bonds ETFs category.


This article is brought to you courtesy of WisdomTree.


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