Federal Reserve Holdings: What to know
Joel Dresang: Marc, the Federal Reserve has already begun to raise interest rates gradually to get them closer to normal, and now the Fed says it’s also going to start unwinding the $4.5 trillion it has in bond holdings. Let’s talk about what that means for investors, but first explain what that $4.5 trillion is.
Marc Amateis: Sure, Joel. Well, think back to the financial crisis, when the Federal Reserve instituted quantitative easing. Basically, what that was, was buying U.S. Treasurys and mortgage-backed securities to drive up the prices – more demand, you drive up the price of something. And, in the case of bonds, when you drive up the prices, you drive down the yields. By doing that, they were able to keep mortgage interest rates low, keep business loans low and help spur the economy. So what happened was, the Fed’s balance sheet went from something under $1 trillion to $4.5 trillion.
Joel: So, how do you expect that they’re going to unwind that $4.5 trillion?
Marc: Well, that’s a good question. We’ve never been here before, so we’ll see. But there’s really a couple things that they can do, a couple ways they can do it. One is to just go ahead and sell those securities – unload them into the open market. That’s probably not the best course of action. More likely, what they will do is gradually allow those securities to mature and pay out and thereby reduce their balance sheet gradually, over time.
Joel: Why is it trying to unwind some of these bond holdings?
Marc: Well, a few reasons. I think one reason is the Fed feels that the economy’s on stronger footing, and so they want to gradually raise rates and get rates back to a more normal level. Remember, we’ve been in an ultra-low interest rate environment for quite some time, and I think just the normalization of interest rates is going to be a good sign for the markets. Another reason is, I think the Federal Reserve just wants to have more bullets in the chamber, so that if we do go into another correction, another recession, they’ve got some ammunition to use to lower rates again
Joel: What effect do you see this having on the bond market?
Marc: Well, again, that’s hard to say because we’ve never been here before. But I think it’s probably pretty safe to say that U.S. Treasurys and mortgage-backed securities will be affected the most, and you’ll probably see their yields rise gradually, over time. There’ll be some spillover, probably into other areas of the bond market. But I don’t think you’ll see a big spike in yields, as you would if, all of a sudden, a whole bunch of supply was dumped onto the market quickly.
The Fed’s been very good about telegraphing their intent about doing things gradually, over time, and when that’s happened, the bond markets really have taken those types of things in stride.
Joel: What should investors be doing?
Marc: I think the first thing is, again, remember why you own bonds in the first place. You own bonds for safety. You own bonds for income. You own bonds to help buffer against a correction in the stock market. That will never change. In addition, I think that bondholders need to keep their durations low. Again, that will protect against a spike in interest rates.
And, lastly, I think you want to look at maybe stepping outside of the box a little bit – away from just bond funds that are plain vanilla – and track the indexes because those are going to be heavily weighted towards U.S. Treasurys and mortgage-backed securities. Investing part of your bond portfolio in a strategic income fund, for example, or a multi-sector bond fund, can allow you to be in other areas of the bond market that may do very well in that kind of an environment.
An approach to bonds amid rising rates, a Money Talk Video with Marc Amateis
How bonds fared as Fed has raised rates, a Money Talk Video with Kyle Tetting
Get the total picture of your investments, a Money Talk Video with Paige Radke
Making the most of mutual fund fees, a Money Talk Video with Isabelle Wiemero
Tips Before You Invest in Bonds, from the Financial Industry Regulatory Authority
Bonds also face investment risks, A Money Talk Video with Tom Pappenfus
(initially posted June 2, 2017)