The bond bears have argued for quite a while that the ultimate unwinding of QE – whenever it happens – will inevitably push interest rates higher.
The Fed (and, by implication, other central banks as well) simply cannot avoid doing considerable damage to interest rates when it eventually begins to unwind its very large balance sheet that is the result of years of QE – or so the argument goes.
I disagree. Of course central bank action could ultimately have some impact on interest rates but nowhere near the levels which are often suggested by the drama queens amongst us.
First and foremost, as pointed out in a speech by Stanley Fischer, Vice Chairman of the Federal Reserve Board, to the Monetary Policy Forum QE in the U.S. has actually been limited in scope compared to many other countries when measured on a relative basis – i.e. as a percentage of GDP.
Secondly, it is not the intention of the Fed to engage in wholesale selling at any point in time. As Stanley Fischer said in his speech:
“Finally, with regard to balance sheet normalization, the FOMC has indicated that it does not anticipate sales of agency mortgage-backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on its existing securities holdings when the time comes.”
Stanley Fischer can hardly say it more clearly. Don’t expect the Fed to flood the market. It just won’t happen. And I would be enormously surprised if other central banks conduct themselves any differently.
In his presentation, Fischer also provided some colour on the composition of the bond portfolio acquired by the Fed through QE and other open market operations (in aggregate called System Open Market Account or SOMA).
As you can see from chart 2 below, a significant part of the portfolio will mature in the next five years, but there will still be bits and bobs left until 2025. If the Fed has no plans to engage in any meaningful selling, one would expect monetary policy to keep interest rates comparatively low for another five-10 years.
It goes without saying that bond investors will, at some stage, begin to discount the ultimate unwinding of central banks’ balance sheets. Fischer estimates – with some help from various researchers – that QE and other monetary policy programmes are currently depressing the term premium on U.S. 10-year Treasury bonds by approximately 110 bps. Ultimately that will go to zero, but only very gradually over the next 10 years or so. So to all those who expect the Fed to ultimately cause a major upward move in bond yields: You’d better be very patient.
Having said that, I am not at all suggesting that monetary authorities will continue to pursue a near zero percent interest rate policy. Not at all. All I am saying is that we are likely to have many years ahead of us where interest rates will be lower than you would normally expect given the overall performance of the economy.
Niels Jensen is CIO, Absolute Return Partners
Comments