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Unwinding the Federal Reserve’s Monetary Policy and How It Can Impact Your Portfolio

October 11, 2017 by The Trust Company of Tennessee

Following the 2008 financial crisis, the Federal Reserve enacted numerous monetary policies to help stimulate the fragile US economy. The Fed aggressively cut the short-term federal funds rate to nearly zero to encourage lending from banks and financial institutions and spending from consumers and corporations. As the economic outlook weakened further, it also announced its decision to buy mortgage-backed securities in November 2008 and later expanded its bond buying program to also include US agency debt and long-term Treasury securities in March 2009. Known as quantitative easing (QE), the Federal Reserve enacted three rounds of QE from 2008 to 2014. During this time, the Fed ultimately bought over $1.6 trillion in mortgage-backed securities and Treasuries. By the conclusion of the QE program, the Federal Reserve had accumulated $4.5 trillion in assets on its balance sheet. At the same time, the Federal Reserve was reinvesting principal payments from mortgage-backed securities, agency debt and maturing Treasury securities.

Growth of the Federal Reserve’s Balance Sheet

Source: Federal Reserve Bank of St. Louis

As the Federal Reserve observed consistent improvements across key economic indicators, the short-term federal funds interest rate was first increased by 0.25% in December 2015. With the fourth and most recent rate hike in June 2017, the Federal Reserve also announced a balance sheet normalization program to begin later this year. In an effort to shrink its balance sheet, the Fed will start gradually reducing the reinvestment of principal payments received from Treasuries, agency debt and mortgage-backed securities. While the Federal Reserve hasn’t provided an explicit optimal size, it has stated that the balance sheet will remain larger than the pre-financial crisis era. Given the unprecedented nature of the Fed’s task, all eyes are directed squarely on the Federal Reserve as it unwinds its balance sheet.

With the Fed beginning to shift its focus, investors are left to wonder about the potential impact on US bonds and equity markets overall.

One of the most impacted areas of the markets will be Treasury securities. The Federal Reserve’s QE program has created strong demand for long-term Treasuries. A recent study estimated that the program has pushed down the 10-year Treasury yield by 100 basis points through 2016 which, in turn, has inflated prices and returns for bond portfolios1. As the Federal Reserve cuts back on the reinvestment of issues that are maturing, we may begin to see long-term yields tick up, negatively impacting returns. Nevertheless, our research has shown that over longer time periods, the increase in yield counteracts the effect of price declines as the periodic coupon payments generated from bonds are invested in higher yielding bonds.2

US equity markets have experienced quite the rebound since the financial crisis. The S&P 500 Index is up 265%3 from March 2009 through August 2017 and volatility has been relatively muted. Corporate earnings are expected to continue growing which could support further positive US equity market returns for the next few years. Similar to its approach in increasing short-term interest rates, the Federal Reserve is expected to be judicious in the unwinding of its balance sheet and proactively communicate its strategy to prevent agitating both equity and bond markets.

A tremendous amount of uncertainty remains in the market and therefore, we continue to endorse diversified, prudent investment portfolios with exposure to both domestic and foreign fixed income and equities in addition to other asset classes.  You will notice The Trust Company is adjusting portfolios this quarter to further diversify holdings and reduce overall risk.  Please contact your relationship manager for questions.

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