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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 2 Important Information This document is for Investment Professionals only and should not be relied on by private investors. This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity. This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. 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For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited 15F, 207 Tun Hwa South Road, Section 2, Taipei 106, Taiwan, R.O.C. Customer Service Number: 0800-00-9911#2 IC17-09 PERSPECTIVE | The Fed’s reinvestment policy 3