Fed’s QE exit
We have known for some time that Ben Bernanke has worried about the build-up of risks stemming from investors’ reach for yield which has ultimately stemmed from the Fed’s highly accommodative monetary policy. On the other hand, we also know that Bernanke is fully cognisant of the risks associated with any sudden pick-up in yields from current depressed levels. Indeed, if bond yields were to rise too quickly upon commencement of the exit process, we would expect the Fed to manage the market’s expectations, possibly by pausing, or even temporarily reversing, the normalisation process.
Interestingly, in his March 1st speech, Bernanke pointed out that if policy rate hikes were implemented too soon this could even cause bond yields to fall. Although he did not explain how, it is our view that one way this could happen would be if an initial rise in yields caused a jump in interest costs, leading to a reduction in disposable income and slower demand for housing.
The 1994 comparison
Of the four rate-rising cycles since 1988, only the 1994 cycle resulted in the US 10-yr yield ending the cycle more than 75bps higher than when the cycle started. Thus only in 1994 did we have a relatively disorderly impact from Fed policy normalisation, with the rate rising cycle resulting in a capital loss on bonds. However, with coupons at 2% or lower, yields rises of 25 basis points or more per year will generate a capital loss.
To be clear, whenever policy rates are normalised, bond yields will go higher. However, that does not mean we will necessarily experience the disorder of 1994. It is difficult to say what the ‘new normal’ for the Fed Funds Rate will be. Assuming equilibrium inflation expectations of 2.5% and an equilibrium real short rate of 1.5%, perhaps 4% is reasonable. The Fed considers the bond yield as decomposed into an expected inflation rate plus an average real short rate plus a term premium. For example, a 2.5% expected inflation rate + a 1.5% real rate and a + 1% term premium, gives a 5% yield. But, it is the speed of the rise that is of critical importance both to investors and the economy. The good news here is that market currently believes it will take more than 10 years to normalise the Fed Funds Rate, implying a slow and manageable rise in yields.
The biggest area of concern for investors will be upward pressure on yields arising from higher inflation expectations as opposed to economic improvement and normalisation. For example, such a situation could arise if the FOMC persisted with a loose monetary stance for too long even as inflation was picking up. While we do not completely dismiss this risk, we feel this is unlikely because the Fed has stated very clearly that it will only unwind monetary accommodation once unemployment drops sufficiently and/or inflation rises beyond its threshold levels. The reference to inflation is key here because it is specifically intended to comfort the market that the Fed won’t allow inflation to become uncontrollable.
Another risk factor worth considering is an increase in the term premium. The most likely cause of this would be a deterioration of the US fiscal situation leading to increasing investor aversion to Treasuries. However, while this is also something that should not be dismissed entirely, we still see few parallels with the 1994 situation, when policy adjustment by the Fed led to a sharp spike in yields in a relatively short time frame. The big difference between now and 1994 is the Fed’s much improved communication with the market. In 1994, yields rose quickly because the market was effectively caught out and surprised by FOMC’s intentions – the FOMC had only recently began to issue policy statements at this time. Today however, we know that the Fed places an immense amount importance on its guidance to the market. Given this, a large rise in yields is only likely if the Fed unexpectedly shifts its stance on how it intends to normalise policy. While such a “blind-siding” in terms of market perception and Fed actions is possible, we think it is unlikely.
The sequence of the exit process is more difficult to predict, because the Fed will want to remain flexible enough to take decisions while the exit process progresses. However, an end to QE will almost certainly be the first step, followed by the winding down of treasury and agency MBS debt that was being rolled over – although this process will take place over the course of many years. As a next step, it’s possible that the Fed raises the interest rate on banks’ excess reserves (IOER) while scaling back the quantity of its reserves via repos (reverse repurchase arrangements) and offering depositary institutions term deposits. Asset sales would be a last resort to reduce the size of the balance sheet – used only in the event that the Fed wants to drain reserves faster than it currently anticipates.
Trevor Greetham, Asset Allocation and Investment Solutions Director, also commented: “Over the longer term, it is natural for bond yields to rise during an economic recovery and this isn’t usually a problem for stocks as long as the rise in yields is orderly. That said, the debate around QE exit is premature. US data has been weak and lead indicators are rolling over. Meanwhile, US headline CPI is 1% and falling. This data is more consistent with easing than tightening.”
By David Buckle, Head of Quantitative Research, Fidelity Worldwide Investment
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