The main issue the bond market faces over the coming 12 to 18 months is that central banks across the world are expected to increase interest rates and at the same time move away from the decade-long unorthodox monetary policy of quantitative easing (QE).
At its most basic, QE involves central banks expanding their balance sheets by creating new money and using it to buy bonds, pushing up prices – and reducing yields – in the process.
Of the world’s central banks, the US Federal Reserve (Fed) is furthest along in terms of the economic experiment of quantitative easing as a policy tool and following its meeting in September 2017, the Fed's interest rate-setting panel, the Federal Open Market Committee, firmly signalled that a December quarter point interest rate rise is still on the table and that the interest rate projections for next year remain largely unchanged with three quarter point rises envisioned in 2018.
The Fed did, however, slow the pace of anticipated monetary tightening expected thereafter forecasting only two quarter point interest rate increases in 2019 and one in 2020. The Fed also lowered its estimated long-term neutral interest rate from 3 per cent to 2.75 per cent, reflecting concerns about the overall economic potential for the US economy.
As far as quantitative easing goes the Fed, as was widely expected, said that from October 2017 it would begin to reduce its $4.2trn (£3.1trn) in holdings of US Treasury bonds and mortgage-backed securities by initially cutting up to $10bn each month from the amount of maturing securities it reinvests.
- The next 12 to 18 months are going to potentially be very challenging for bond investors.
- So far markets have been unperturbed by the prospect of the Fed increasing interest rates.
- Many investors fear heightened volatility as central banks change course.
The Fed ended formal quantitative easing in 2014 as the economy strengthened, but has since kept its balance sheet high by reinvesting the proceeds of existing bonds as they have matured. The limit on reinvestment is scheduled to increase by $10bn every three months to a maximum of $50bn per month until the central bank’s overall balance sheet falls by $1trn or more in the coming years.
To be frank, to date, markets have been unperturbed by the prospect of the world’s most powerful central bank increasing interest rates and reversing quantitative easing. US economist Janet Yellen has predicted the process will be as uneventful as watching paint dry, although a cynic might think she would say that.
Unfortunately an issue for some is that there is no agreement/consensus on what the future “new normal” for the size of the Fed’s balance sheet will, or should, be – or what the appropriate long-term neutral interest rate is likely to be.
There is also the fact that there could be big changes on the board of the Fed. US President Donald Trump has the potential of installing as many as five new members to the seven-seat board in coming months, including possibly replacing Ms Yellen whose fixed term comes up for renewal in February 2018. This could drastically change the Fed’s future monetary policy.
In simple terms it is likely Mr Trump’s new nominees to the Fed board will shift monetary policy from infrequent and small interest-rate hikes (in the hopes of triggering lower unemployment and more growth) to more aggressive rate hikes (in the hopes of hitting inflation targets).