Bond Market’s Dilemma Isn’t So Bad After All
by Liz McCormick, Daniel Kruger, Kasia Klimasinska
For bond investors worried about what might happen when the Federal Reserve starts whittling down its $2.46 trillion of Treasuries, there’s good news.
You’ll barely even notice.
The central bank plans to reduce its debt holdings sometime after it starts raising interest rates, and the concern is that the Fed’s attempt to reverse its unprecedented easy-money policies will trigger a jump in borrowing costs.
But even if the Fed doesn’t buy any bonds to replace the $216 billion in Treasuries coming due next year, yields would hardly budge, according to JPMorgan Chase & Co., which looked at how much they moved during the Fed’s debt-purchase program.
“It would not have an impact, and that’s the news here,” said Lou Crandall, chief economist at Wrightson ICAP LLC, a research firm that specializes in analyzing Fed policy and Treasury financing. “Letting Treasuries run off is a freebie.”
It’s the latest surprise in a market that keeps confounding Wall Street’s best and brightest, who have repeatedly gotten it wrong calling for the end to the bull market in bonds.
Keeping a lid on yields is not only critical for investors, but it’s also crucial for the U.S. government as it finances a debt load that’s more than doubled to $18 trillion since the credit crisis. And the implications extend to governments, businesses and consumers around the world as Treasuries serve as the benchmark for trillions of dollars of debt globally.
The Fed ended its bond-buying stimulus, popularly known as quantitative easing, or QE, in October 2014, but it’s been maintaining the size of its holdings by reinvesting money from maturing debt into more securities.
In the past five years, the central bank spent almost $200 billion on reinvestments in Treasuries alone.
With the U.S. economy on the upswing, the worry is that the Fed will upend the bond market as it starts unwinding the most aggressive stimulus measures in its history.
In addition to raising rates by year-end, a majority of forecasters expect the Fed will let some debt securities mature in the first half of 2016 without plowing the money back into the bond market. Apart from Treasuries, the central bank has also amassed $1.73 trillion of mortgage-backed securities and now holds a total of $4.2 trillion of bonds.
By pulling back, the Fed will start removing one of the biggest sources of Treasuries demand, which has suppressed borrowing costs and helped the U.S. recover from its worst recession in decades.
Since the Fed dropped rates to rock-bottom levels in 2008 and embarked on QE, yields on the U.S. 10-year note have fallen from 4 percent to about 2.15 percent today.
“I don’t see how it can’t” push yields higher, said Thomas Simons, a government-debt economist at Jefferies Group LLC, one of 22 dealers that trade directly with the Fed.
JPMorgan’s analysis suggests the increase isn’t likely to be significant. If the Fed allowed all of its Treasuries that mature in 2016 to run off its balance sheet, 10-year yields would rise by about 0.05 percentage point.
The top-ranked firm for fixed-income research by Institutional Investor magazine based its analysis on how much Treasury yields fell when the Fed was buying bonds, which equaled about 0.2 percentage point for every $1 trillion of QE.
Using that math, the Fed’s $1.3 trillion of Treasury holdings that come due through the end of the decade may boost 10-year yields by less than 0.3 percentage point.
The Treasury Department isn’t taking any chances. It’s considering steps that would mitigate potential disruptions to U.S. funding and has signaled it will boost issuance of the shortest-dated debt to plug a potential gap of as much as $850 billion through 2018 if the Fed stops reinvesting.
The move would bolster bill supply, which has fallen to multi-decade lows, at a time when regulations may cause demand to soar as much as $900 billion, according to JPMorgan.
In any case, there are plenty of reasons for the Fed to take it slow. With rates pinned near zero since 2008, the central bank may want to make sure its first rate increases don’t choke off economic growth before paring its debt holdings.
Joblessness is at a seven-year low, yet U.S. workers can’t seem to get the pay raises to allow them to spend more.
Consumer prices fell in three of the first six months of the year and traders are questioning whether inflation will reach the Fed’s 2 percent goal any time in the next 10 years.
New York Fed President William C. Dudley told reporters after a June 5 speech in Minneapolis that he’d want rates at a “reasonable level” first before ending reinvestments.
“How far that is — you know, if it’s 1 percent or 1.5 percent — I haven’t really reached any definitive conclusion,” Dudley said.
Futures traders don’t expect rates to reach 1 percent until at least December 2016, data compiled by Bloomberg show.
The uneven housing recovery may also persuade the Fed to continue its reinvestments in mortgage securities. The central bank has been the biggest buyer of mortgage bonds guaranteed by Fannie Mae and Freddie Mac, which has supported demand since the U.S. housing bust.
“They’re not going to go cold turkey,” said George Goncalves, the head of interest-rate strategy at Nomura Holdings Inc. “I think they taper the reinvestments.”