Download The Fed`s reinvestment policy

PERSPECTIVE
FEBRUARY 2017
This is for investment professionals only and should not be relied upon by private investors
The Fed’s reinvestment policy
The Fed currently reinvests the cashflows from Treasuries and mortgagebacked securities (MBS) it holds as a result of its QE programmes, as well
as buying MBS outright. Stopping or reducing this reinvestment, and
therefore shrinking the size of the Fed balance sheet, has come under
scrutiny as members of the Fed debate ways to tighten monetary policy.
The general expectation at the moment is for the Fed reinvestment policy
to change around the middle of 2018, based on earlier comments by some
FOMC members that full reinvestment can stop after another three to four
hikes (notably William Dudley).
Yet this would be contingent on the Fed raising rates in line with
expectations - and doing so at a time of significant policy and economic
uncertainty. The side effects of a stronger dollar could impede the Fed in
reaching its inflation target, as well as having other, potentially negative,
side effects on the economy. What’s the likelihood we’ll see a reduction in
the balance sheet, and what opportunities does this create? Anna
Stupnytska, Global Economist, and Rick Patel, Portfolio Manager (Fixed
Income) share their thoughts.
Anna Stupnytska: My view is that it’s too early to worry about the impact of
changing reinvestment - in fact, I think this timeline is far too ambitious. Political
uncertainty aside, the economy is not yet at the stage where the risks of a
return to the zero bound are too low and the Fed funds rate is still far below a
more ‘normal’ level. I think growth and inflation will disappoint this year and the
Fed will not be able to hike as fast as the dot plot currently suggests. As such,
there will be no pressing need for the Fed to start forward guidance on the
balance sheet issue this year.
In other respects, it’s not surprising that some commentary has already started.
The Fed will want to gauge the possible market reaction given the uncertainties
about the potential impact of ending the programme. In addition, the Fed has
signalled higher confidence in the economy, so it makes sense to bring balance
sheet discussions back on the table. But I do not expect anything concrete
beyond that for now - Yellen might want to talk about the framework in the runup to the expiry of her term in February 2018. Balance sheet plans will also
depend on Trump’s plans for regulation changes and fiscal policies.
One thing that can potentially accelerate the decision to end full reinvestment is
US dollar strength. If the Fed wanted to shift to tighten financial conditions but
limit the effect on the currency, then they could stop full reinvestment sooner.
However, I do not expect the kind of substantial US dollar strengthening over
the next few months to necessitate this.
ANNA STUPNYTSKA is the Global
Economist within Fidelity Multi
Asset. Anna joined Fidelity from
Goldman Sachs Asset
Management, where she was a
Macroeconomist.
Anna holds a first class honours
degree in Economics from the
University of Cambridge and a
Masters of Philosophy in Economics
(with Distinction) from the University
of Oxford.
RICK PATEL is fixed income
portfolio manager at Fidelity
International. He joined Fidelity in
2000 as a Quantitative Analyst and
progressed to become a Portfolio
Manager in 2007.
Prior to joining Fidelity, Rick worked
as a Fixed Income Research
Analyst at Prudential, London. Rick
has a B.A. Mathematical Sciences
from Oxford University.
In fact, I believe that the Fed might not even have the luxury to end the
reinvestment programme before its balance sheet will have to be expanded
again. The end of the cycle is not that far off and it’s unclear how Trump’s
policies will affect that; there are clear risks that he will shorten the cycle.
Rick Patel: I don’t believe the Fed will stop Treasury reinvestments any time
soon, if at all, but the outlook for MBS is more uncertain. Ceasing reinvestments
and purchases of MBS is more straightforward for the Fed, and markets are
beginning to price in the wind-down. We’ve already seen weakness in the asset
class due to higher interest rates, and further widening of spreads will make
valuations more appealing. While we find US yields attractive at current levels,
the MBS sector looks increasingly interesting and we are starting to add
exposure across the global funds.
I believe the chatter around the balance sheet is part of the Fed’s strategy to
‘test the water’ in a bid to avoid a repeat of the 2013 Taper Tantrum. They’ve
learnt that often their words speak louder than actions, but in this instance any
action is some way off. The comments are also a release valve for dollar
strength, as too strong a currency can cause problems for the Fed and the
Administration, as well as for corporate profitability.
PERSPECTIVE | The Fed’s reinvestment policy
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