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CIP Quips

It's Hard to Unwind

What’s in the news:

In an effort to alleviate the effects of the 2008 financial crisis the Federal Reserve’s quantitative easing program was introduced to drive down longer termed interest rates. The idea was to encourage people to spend more, and the program ultimately more than tripled the Federal Reserve’s balance sheet.

Almost a decade later at the March 2017 FOMC meeting, the Fed acknowledged that its balance sheet needs to be unwound, but the timing of that still remains unclear.

Even though the Fed stopped buying securities in 2014 it continues to hold a huge balance sheet and reinvests the proceeds of its portfolio. And while many market participants expect the Fed to start unwinding by the end of 2017 or the beginning of 2018 many questions still lurk in the midst:

  • How will the fed begin a gradual reduction? 
  • What will the process look like?
  • What would be the effects on the longer termed treasury securities, mortgage-backed securities (MBS) and Government Sponsored Enterprise securities (GSE) sitting on the balance sheet?

The timing of unwinding can be done in various ways depending on the securities, and the process could take some time and have minimal market impact if managed correctly.  

What are we thinking?

The chief global strategist at J.P. Morgan recently stated that “higher short [term interest] rates provide increased income to savers while slow-rising long [term interest] rates would only have a small negative impact on the borrowing behavior of corporations and home-buyers. Of course, the Fed could see this and try to boost long rates by normalizing their balance sheet faster”.

Unwinding the balance sheet has, albeit unintended, similar effects on the market as an interest rate hike.  And former Federal Reserve Chairman Ben Bernanke told Bloomberg Television last week that, “it would likely take the Fed four to five years to get the balance sheet to a sustainable level once it begins the normalization process.” So could this unwinding process be the promise of scheduled interest rate normalization?

As income investors, we attempt to offset the price risk of rising interest rates by counterbalancing longer maturity investments with shorter maturity issues.  Our shorter maturity issues are currently scheduled to approach maturation in the time frame that the Federal Reserve is expected to raise interest rates, providing a more attractive landscape to invest in. In any environment that is data dependent, monitoring risk metrics to ensure optimal yield curve positioning guides us in our attempt to enhance portfolio income. 

 

Additional Source: MarketWatch



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