Fed hiking cycle may spark unusual bond market reaction
The prospect of the Fed shrinking its balance sheet may see the bond market react differently to economic data than we might expect.
Following the global financial crisis the Federal Reserve (Fed) bought large quantities of financial assets, consisting mainly of Treasuries and mortgage backed securities. As a result, the size of the Fed’s balance sheet rose from less than $869 billion in August 2008 to nearly $4.5 trillion today.
However, in March, Bill Dudley of the New York Fed introduced the idea that after two more hikes of the federal funds rate the US Fed would look to begin to shrink its balance sheet.
Although it was short on specifics, the subsequent release of the minutes of the last Fed meeting said that the Fed’s balance sheet may need to begin to unwind late in 2017.
So, what does that mean for bond markets?
We believe the idea of balance sheet "removal" introduces the prospect of a completely different and unusual bond market reaction to economic data than what might be expected.
In our opinion, assuming the Fed doesn’t feel it is falling behind the curve if it tightens too slowly, strong data will begin to impact the long end of the market as it increases the likelihood of the removal of balance sheet accommodation.
In rate markets, the seven- to 10-year bucket is most vulnerable to the removal of mortgage market support. Risk assets (equities/credit) will have to come to terms with potentially higher volatility, steeper yield curves and higher rates.
It also means that we may witness a flattening of the front end of the curve, a richer (more expensive) “belly” of the curve, and a steeper intermediate vs. long end of the curve. These would all be very unusual to a “traditional” Fed hiking cycle.
Despite a typical hiking cycle causing a flattening of the yield curve, we are potentially embarking on a path where yield curves may steepen significantly, as the Fed may be concluding that financial conditions (i.e. stock prices) can only be impacted by engineering a steeper yield curve and higher term premium.