The Federal Reserve has spent the last six years and over $2 trillion buying up bonds in order to depress bond yields and stimulate the economy. The government purchases of U.S. Treasuries have pushed up bond prices and driven investors into equities.
In October 2014, the Federal Reserve announced an end to its stimulus program, 10 months after tapering down its purchases. Over three quantitative easing rounds, the Fed has amassed $2.4 trillion worth of assets on its balance sheet. The name of the game has been liquidity, i.e. make money cheap and easily available.
Now that the QE era is over, what does the future look like?
Let’s go back to May 2013 when then-chairmen Ben Bernanke triggered a “taper-tantrum” when he spoke of the Fed reducing the amount of its bond purchases. He didn’t say it was coming to an end, just that the Fed would buy less than it had previously. Investors, frightened, unleashed a wave of volatility in the bond market.
In the figure above you can see yields on 10-year U.S. Treasurys went from 1.6% in the summer of 2013 to 3% by the end of the year.
That’s not all
While all this was happening the Fed also lowered the federal funds rate, the rate at which banks borrow from the government, to near zero. The lower the rate, the cheaper it is for banks to borrow money and subsequently lend it out. The Fed will want to raise this rate, now that tapering is over and the U.S. economy seems to be on track.
Expect a messy exit.
What we need to watch for is how the Fed handles the transition to tighter monetary policy.
Generally increases in the fed funds rate translates to higher interest rates on Treasurys. When money is harder to get, people have to gain some sort of incentive to lend.
When interest rates rise there will be uncertainty. Remember the huge jump in yields in summer 2013 – the so-called “taper tantrum”? And at that time the Fed didn’t even take any action! The mere expectation of rising interest rates was enough to cause havoc.
Finally, there is the issue of capital flight in the emerging markets. As rates rise investors will likely be pulling their marginal dollars from emerging markets to invest in “risk-free’ U.S. Treasurys.
How this all plays out can be orderly…or not.