The Federal Reserve (Fed) has purchased more than $4 billion of bonds since 2008 through multiple quantitative easing (QE) programs, in order to decrease supply in the market and push interest rates lower. Even though the latest QE program in the U.S. ended more than two years ago (October 2014), these holdings, known as the Fed’s balance sheet, have remained stable. The Fed has rolled the proceeds from maturing bonds into new purchases, keeping the size of the Fed’s balance sheet relatively constant over the past few years, and also likely keeping rates slightly lower than they otherwise would be.
Over the past few weeks, several Fed presidents, including Rosengren (Boston), Williams (San Francisco), Kaplan (Dallas), and Harker (Philadelphia) have mentioned the idea of stopping the reinvestment of proceeds from maturing bonds, a policy that would allow the Fed to reduce the size of the balance sheet gradually over time. This concept is not new, and market participants have been asking the Fed about its QE exit strategy since the announcement of QE1 in November 2008. However, the fact that several Fed presidents are bringing the idea up at the same time means that a broader discussion is likely happening within the Fed.
Although we don’t believe such a decision is imminent, we thought it would be interesting to take a look at the composition of the Fed’s balance sheet to see how much the bond market might be impacted by such a move. The Fed publishes data on its balance sheet each week in a statistical release known as H.4.1. The table below shows holdings in two major asset classes: Treasuries and mortgage-backed securities (MBS). These assets make up approximately $4.2 trillion of the total $4.5 trillion on the Fed’s balance sheet and are of the most interest to markets.
As the table shows, a shift in policy wouldn’t lead to an immediate impact, though market reaction is forward looking and the implementation of such a policy could lead rates to rise ahead of actual policy implementation. Over the course of a few years the impact could become larger, with $1.2 trillion in Treasuries maturing within one to five years. On the MBS front, the impact would take a little longer to feel, as the majority of the $1.7 trillion in MBS on the Fed’s balance sheet will mature in more than 10 years, though the potential for mortgage borrowers to pay down their loans early (refinancing, home sales, or even just additional payments) means that the impact could end up being felt sooner.
To reiterate, the Fed hasn’t indicated an immediate move to this policy, and we don’t have reason to believe that it will be implemented in the near term. But being prepared is half the battle, and the fact that Fed speakers have brought the idea up multiple times in recent weeks makes the issue worth watching.
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.
The economic forecasts set forth in the presentation may not develop as predicted.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Mortgage-backed securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
Quantitative Easing (QE) refers to the Federal Reserve’s (Fed) current and/or past programs whereby the Fed purchases a set amount of Treasury and/or Mortgage-Backed securities each month from banks. This inserts more money in the economy (known as easing), which is intended to encourage economic growth.
This research material has been prepared by LPL Financial LLC.
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