As we expected, the Federal Reserve (Fed) left short-term interest rates unchanged at the September 19-20 meeting of the Federal Open Market Committee (FOMC). Despite a relatively upbeat assessment of economic activity and labor market gains, the Fed opted to hold rates steady, indicating current inflation and longer-term inflation expectations remain low. The Fed cited the recent hurricanes as temporary factors affecting the national economy, but it does not expect the storms to materially alter the course of economic growth or inflation over the medium term. The Fed also hinted a December rate hike is not off the table.
Also as expected, balance sheet reduction moved to the Fed’s forefront. Nearly nine years after making “quantitative easing” (QE) a household term, the Fed announced it will begin unwinding its unprecedented bond-buying program that inflated the central bank’s balance sheet to a record $4.5 trillion. With the economy on stable footing and interest rate normalization underway, the Fed is set to restore normalcy to the remaining component of its stimulus program.
Fed Enters Uncharted Waters, Again
In the aftermath of the financial crisis, the central bank entered uncharted waters, launching a bold and unparalleled program of massive bond buying to boost lending, support the financial markets, and battle the Great Recession. During the six years the Fed operated its QE program—from 2008 to 2014—the central bank purchased nearly $4 trillion in U.S. Treasuries and mortgage-backed securities (MBS).
Now, the Fed is once again entering uncharted territory as it seeks to reduce its stockpile of assets. Although the Fed ended QE in October 2014, it continues to reinvest all principal payments from its holdings back into the Treasury and MBS markets. This activity has provided continued support for the bond market—support that if ended abruptly potentially could drive interest rates sharply higher and derail economic growth.
However, as the Fed’s September 20 announcement indicates, the central bank will pursue balance sheet normalization the same way it’s seeking interest rate normalization—slowly, gradually, and transparently. Rather than engaging in the outright selling of securities, the Fed is pursuing what it hopes will be a much-less-disruptive approach.
The Fed’s plan allows a set amount of securities to roll off the balance sheet each month, once the securities mature. Initially, the Fed will allow $6 billion in Treasury securities and $4 billion in MBS to roll off, beginning in October. The net monthly maturities will increase every three months—by $6 billion for Treasuries and $4 billion for MBS—eventually rising to a maximum of $30 billion in Treasuries and $20 billion in MBS.
The Fed will keep the caps in place until it holds “no more securities than necessary to implement monetary policy,” according to the June-FOMC meeting statement. The Fed expects to shrink its balance sheet to a level “appreciably below that seen in recent years but larger than before the financial crisis.”
Slow, Steady Approach Should Reassure Markets
This steady approach in an environment of modest economic growth and weak inflation—and healthy demand for Treasuries—should limit any significant bond market disruptions. Although the MBS sector may be vulnerable to some modest yield pressures as the Fed tapers its reinvestment activity, we do not expect a significant spike in yields.
Short-maturity interest rates are directly influenced by Fed actions, but longer-maturity rates and yields are more market driven. Supply and demand for bonds, geopolitical factors, and expectations for inflation and economic growth are key influences on longer-maturity rates.
Market conditions have kept longer-maturity U.S. Treasury yields in a tight range so far this year, as investor expectations for stronger growth, a boost in infrastructure spending, and higher inflation have moderated due to political gridlock in Washington, D.C. Investors initially expected President Trump’s pro-growth policies would usher in stronger growth and higher inflation in 2017. But much of the president’s agenda remains stalled, which is helping to hold down longer-maturity rates. In addition, the difference in rates between the U.S. and other developed markets continues to prevent a breakout to significantly higher rates in the U.S.
Given this backdrop, we expect the 10-year Treasury yield to remain in a range of 2.00 percent to 2.60 percent for the next 12 months, barring any big surprises in U.S. or global economic conditions.
 The Fed’s portfolio of Treasuries and mortgage-backed securities (MBS)
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of Dave MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.