How Will The End Of QE Affect The Bond Markets? (AGG)
Tom Reese
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From Invesco: Quantitative easing was a response to the financial crisis of 2008; it involved large-scale purchases of US Treasuries, agency paper and mortgage-backed securities by the US Federal Reserve (Fed).
By acquiring these securities from large banks and primary dealers, the Fed increased the national money supply — helping to ease the US out of recession — but also ballooned its balance sheet to more than $4.5 trillion.1Nearly a decade since quantitative easing was first implemented in late 2008, the Fed has disclosed a plan for unwinding its asset purchases and reducing its balance sheet. This process, known as tapering, involves selling securities and not reinvesting maturing assets, thereby removing liquidity from the financial system and potentially raising interest rates.
Fed tapering efforts complicated by fundamentals, debt ceiling talks
While the Fed would like to begin tapering as soon as possible, the central bank’s Federal Open Market Committee (FOMC), which sets monetary policy, operates under a mandate to increase rates based on forward-looking economic and inflation forecasts, which have been mixed of late. Complicating matters is a possible debt ceiling standoff in Congress, with Republicans seeking spending cuts as part of any bill to raise the ceiling, and Democrats opposing them. As a result, many bond investors have stayed on the sidelines, and three- to 30-year Treasury yields have remained in a relatively narrow range throughout most of 2017.
The last time the debt ceiling issue affected the financial markets was 2011. While the debt limit was ultimately raised after a tense showdown in Congress, the mere possibility of the US defaulting on its debt obligations resulted in market disruptions, including a jump in short-term Treasury bill yields and a rise in market measures of US Treasury default risk.
What might fixed income investors expect from Fed tapering?
The FOMC is expected to announce the formal start of tapering at its Sept. 20 meeting, with Treasury and possibly agency or mortgage-backed security reductions expected to happen in October. According to the Treasury Borrowing Advisory Committee, a panel of senior executives from leading industry investment funds and banks, tapering is estimated to result in the following changes to the Fed’s balance sheet:
Fed assets of around $2.5 trillion in Treasuries are expected to shrink to about $1.7 trillion by 2021.2
Fed assets of around $1.8 trillion in agencies and mortgage-backed securities are expected to shrink to about $1.2 trillion by 2021.2
Ending bank reserves are expected to drop by $1.5 trillion to around $650 billion.2
While these are merely estimates, the basis for the panel’s projections seems reasonable, in my view. A reduction of this scale in the Fed’s balance sheet means that it is selling assets and removing a large amount of liquidity from the financial system — a process designed to drive interest rates higher. Given these prospects, investors may want to position their portfolios accordingly.
Here are several potential strategies for weathering the coming tapering cycle. These are not recommendations, and investors should consult their financial advisors before making investment decisions. But given the prospect of higher yields, I believe these ideas could make sense in some cases.
Duration barbellstrategy – While 10- and 30-year yields could gradually rise, I believe global demand for yield will help prevent the long end of the Treasury yield curve from steepening too abruptly heading into next year. Conversely, I believe the six-month to three-year portion of the yield curve is more likely to rise, which could lead to a flatter overall yield curve. If this comes to pass, a duration barbell could make sense, targeting a combination of ultra-short and mid-to-long duration securities.
Non-core spread products – Many fixed income investors are overweight corporate credit. Those looking for increased diversification may wish to complement core corporate allocations with additional spread (non-Treasury) assets, such as municipal bonds, emerging market debt, preferred securities, securitized debt and non-dollar-denominated debt.
Floating rate products – The coupons on floating rate bonds are structured to adjust upward as interest rates rise, making them well-suited for a rising rate environment. The combination of Fed tapering, potential rate hikes, an increase in Treasury bill yields ahead of the debt ceiling debate and the potential for improving US economic growth and rising inflation all point to floating rate securities as a compelling option for fixed income investors, in my view.
PowerShares by Invesco provides a full array of innovative income solutions, including equity income products, as well as investment-grade and high yield credits with a wide range of maturities.
1 Source: Board of Governors of the Federal Reserve System 2 Source: US Department of the Treasury
Important information
Correlation is the degree to which two investments have historically moved in relation to each other.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates, and is expressed as a number of years.
The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
Quantitative easing is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.
A “spread” fixed income product is a taxable bond that is not issued by the US Treasury.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
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Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
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Obligations issued by US government agencies and instrumentalities may receive varying levels of support from the government, which could affect the fund’s ability to recover should they default.
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The iShares Barclays Aggregate Bond Fund (NYSE:AGG) was unchanged in premarket trading Wednesday. Year-to-date, AGG has gained 3.00%, versus a 10.82% rise in the benchmark S&P 500 index during the same period.
