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Investors and consumers have been hearing about the pitfalls of rising interest rates on their fixed income investments for years. We are starting to feel complacent since the Federal Reserve Board has been very cautious in their interest rate hikes this year. But wait — what is this news about unwinding a balance sheet?
The Federal Reserve Board announced at their September FOMC meeting that they would start to normalize their balance sheet. This is not something most people are familiar with since it is a phenomenon that was created out of the 2008 financial crisis.
In 2010, then Fed Chair Ben Bernanke created a policy known as quantitative easing. His theory was that easier financial conditions would promote economic growth and help lift us out of a horrible recession.
During the time of quantitative easing, the Fed purchased U.S. Treasury bonds and mortgage-backed securities to create liquidity in the financial markets.
Now it plans to let those bonds mature and roll off the balance sheet at a rate of $50 billion per month or $600 billion per year. These sound like big numbers and may warrant our attention to at least understand how it impacts our bond investments.
Columbia Threadneedle Investments produced a recent report to help decipher this Fed policy that began last month. When short-term interest rates reached zero in 2008, the Fed created a “shadow” rate that translated bond purchases into interest rate equivalents. From 2009 through 2014 the Fed purchased $2.2 trillion in assets with a shadow rate of -2.81 percent.
Therefore, purchasing these bonds had the same effect on markets as if the Fed had lowered interest rates by 2.81 percent. Of course, they could not lower them below zero, but these bond purchases in essence created negative interest rates for the United States during the time of quantitative easing.
Now the reserve is occurring. The Fed’s planned balance sheet decline of $600 billion would be equivalent to an increase in the Fed funds rate of 0.76 percent, or about three rate hikes of a quarter point each, every year. Therefore, even if we don’t hear about the Fed actually increasing interest rates, they are rising as a result of them reducing the amount of bonds they own on their balance sheet.
Certain types of bonds will be affected differently. U.S. Treasuries with longer maturities will be most likely to lose value. Corporate bonds could hold up better as these usually track the health of the underlying company. Mortgage-backed securities reward investors for taking on this risk and the liquidity may improve.
Diversification in your investments is paramount but should include a deeper dive than just stocks and bonds. It is also important to diversify within your stock and bond holdings.
If you are concerned about rising interest rates, you can hold shorter-term or corporate bonds. If you are concerned the stock market may adjust, make sure your equities are diversified across country, size, value and growth potential.
Uncertainty remains at high levels around future interest rate hikes, the continued balance sheet asset reduction, and now concerns about who the next Fed chairperson will be. As boring as bonds may be, there is never a dull moment at the Federal Reserve Board.
Patricia Kummer has been an independent Certified Financial Planner for 31 years and is president of Kummer Financial Strategies Inc., a Registered Investment Advisor in Highlands Ranch. Kummer Financial Strategies Inc. is a seven-year 5280 Top Advisor. Please visit www.kummerfinancial.com for more information. Any material discussed is meant for informational purposes only and not a substitute for individual advice.
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