Will the Federal Reserve start winding down its bond holdings?

The US Federal Reserve may finally start reducing its bloated balance sheet. 

Since Donald Trump’s election, the S&P 500 has risen more than 10% while the US 10-year bond rate has also risen, from 1.85% to 2.39%.

Known as the ‘Trump trade’, investors are betting that a combination of tax cuts, infrastructure spending and deregulation will increase US economic growth and inflation from the mediocre levels suffered under his predecessor, who was much less friendly towards the private sector. 

Whether – and in what form – Trump’s policies become law is of course the yuuuge question. However, it’s likely that some tax reform and infrastructure spending bills are enacted and that the trend towards deregulation continues.

A happy consequence is that the Federal Reserve is finally getting around to normalising short term interest rates. The Fed raised rates late in 2016 and also in March 2017 and is currently predicting two more rises this calendar year. That US inflation is ticking up is helping on this front.

Perhaps of more consequence, though, is that the Fed is also now considering reducing its bloated balance sheet. Due to its purchase of government bonds and mortgage securities, the Fed’s assets now total a staggering US$4.5 trillion, up from less than US$1 trillion before the GFC.

Quite remarkable

The effect of the Federal Reserve’s extraordinary actions since the GFC was noted by US hedge fund manager David Einhorn in October last year:

I read a speech today or yesterday from the vice chair of the Fed. He said, "I wonder why rates are so low." Well if you set rates at zero and you hold them at zero for six years, you buy up a big percentage of the government bond market, tell everybody if rates ever go up you’re going to buy more government bonds, you basically corner the market, and then you wonder what the bond prices are reflection. I think it’s really quite remarkable.

So do I.

Einhorn also believes that, by keeping interest rates so low, the Federal Reserve has actually impeded rather than encouraged economic growth, due to the resulting lower income offsetting any benefits from lower rates.

Thankfully, along with a more private sector-friendly administration, both sets of headwinds are now potentially becoming tailwinds.

So assuming the Federal Reserve does start reducing its balance sheet, I’ll be interested to see the effect, if any, on US long term interest rates.

Effect on Australian rates

While this may appear to be a US-centric conundrum, it may also affect Australian rates. 

Firstly, the higher yields on Australian government bonds versus many foreign government bonds have made Aussie government debt more attractive to foreign investors. 

Along with higher yields on commercial property and other ‘bond-equivalents’ such as infrastructure, the prices of these assets have also risen, at least in part, for similar reasons.

However, with Aussie ten-year bond yields being highly correlated to US bond yields, any narrowing of this gap will make Australian bonds and ‘bond equivalents’ less attractive, potentially lowering their prices and increasing their yields. 

Moreover, with Australia’s banks still sourcing much of their funding from overseas, foreign investors may require higher rates to continue lending to Aussie banks. This will flow through to mortgage rates and potentially affect house prices.

Macroeconomic predictions dangerous

Of course, macroeconomic predictions are always fraught with danger. So I won't try to predict where interest rates – or house or commercial property prices – will be in one, five or ten years' time.

However, I think ignoring the massive influence governments and central banks have had on interest rates since the GFC is unwise, especially now that the policies of both, at least in the US, are changing.  

This is especially relevant for investors who are assuming low interest rates continue indefinitely to justify their investments in commercial property, residential property or any other investment highly sensitive to rising interest rates. 

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