Picture it: March 2009. In response to the great financial crisis, the Fed begins quantitative easing (QE)—a type of monetary policy in which a central bank buys government bonds to lower interest rates, making money “cheaper” for consumers to borrow. The Fed vacuums up U.S. Treasury bonds and mortgage-backed securities, and its balance sheet swells.
All (good?) things must come to an end
Fast forward to September 2017: Fed Chair Janet Yellen makes it official that it’s time to pay our final respects to QE.
This policy shift leads to a couple of questions:
- What are the ramifications for bond yields?
- How will this decision affect the composition of fixed income benchmarks?
Before jumping into the answers, or at least my best guess at the answers, it’s important to understand how QE will fade away. The key words to remember are gradually and passively. Gradually is self-explanatory—a little at a time. We say passively because the Fed isn’t interested in selling securities from its balance sheet—it simply won’t replace a portion of the securities when they mature.
Will bond investors mourn for QE?
We don’t expect the end of QE to influence bond yields. Rather, we anticipate that bond yields will continue to follow the rate path currently priced into the market.
To describe how the market may react to this change in supply and demand, I’ll offer another key word: predictable. The Fed has taken a measured approach to removing policies that stimulate the economy, such as interest rate hikes and QE.
Since the market has been expecting the end of QE, we believe current interest rates reflect the market’s collective view of a post-QE world. Unless the Fed significantly deviates from its stated course, we don’t expect a big upset in bond yields.
How will the end of QE affect bond benchmarks?
The answer to this question is more concrete: Float-adjusted and non-float-adjusted benchmarks will begin to converge.
Float-adjusted indexes exclude Fed-owned securities (including U.S. Treasuries, mortgage-backed securities, and U.S. agency securities) that aren’t available to investors. A float-adjusted index, compared with a non-float-adjusted index, more accurately represents the supply in the marketplace because it only includes shares that are available for investors to trade.
The end of QE means that newly issued Treasury and mortgage-backed securities, which previously would’ve been purchased by the Fed, will now be available on the bond market—and therefore represented in float-adjusted benchmarks. All things being equal, this will gradually increase the weight of these government securities (and reduce the weight of nongovernment securities) in multisector benchmarks that include the broadest representation of the investable market, such as the U.S. Aggregate Bond Index.
Defining the market
Of course, markets aren’t static. As the market’s composition changes, the index’s composition will change to reflect the market. The weight of U.S. Treasuries in the U.S. Aggregate Bond Index is 37%, which is slightly higher than the long-term average of 32%. And it’s about equidistant between the maximum weight of 50% (reached in 1986) and the minimum weight of 21% (observed in 2002). No matter how the weightings ebb and flow, the U.S. Aggregate Bond Index is the market.
Farewell, QE
QE is slowly dying out, and hopefully, it will be remembered as a historical curiosity. In the meantime, investors should take comfort in the combination of the market’s efficiency and the Fed’s deliberate approach.
Given these observations, we shouldn’t forget that the market can surprise us. It has a way of humbling even the savviest prognosticators. Fortunately, there are a few actions consistently linked with success: keeping costs low and sticking to a long-term asset allocation.
Notes:
- All investing is subject to risk, including the possible loss of the money you invest.
- There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
