Federal Reserve Chairwoman Janet Yellen said she expects the shrinking of its massive balance sheet, due to start later this year, will be as exciting as "watching paint dry," but the unknown effects on U.S. and global markets are keeping fixed-income managers and investors on alert.
"The Fed is writing the rules of engagement as we speak," said Steve Bartolini, portfolio manager in T. Rowe Price Group Inc.'s U.S. taxable group in Baltimore. "It has never before managed such a large balance sheet. The impact of reducing it, even at a glacial pace, is untested." T. Rowe manages $195.7 billion in fixed income.
Making the announcement June 14, members of the Federal Open Market Committee took pains to give market participants plenty of time to prepare for what is expected to be a slow, predictable unwinding by not reinvesting maturing assets.
For maturing securities, the committee anticipates an initial cap on assets allowed to mature of $6 billion per month that will rise $6 billion every three months for a year until reaching $30 billion per month. For agency debt and mortgage-backed securities, a monthly cap of $4 billion per month will settle at $20 billion per month over the same 12 months.
Fixed-income managers say they, and the markets, have anticipated this next chapter.
"It is largely priced in right now, although that doesn't mean there can't be unforeseen incidents," said Richard Clarida, New York-based managing director and global strategic adviser for Pacific Investment Management Co., which runs $1.51 trillion in fixed income. "The one thing that we don't know, because they haven't made up their mind, is when does this process stop?"
When it is all over, the Fed still will have a large balance sheet compared to the $866 billion in assets it held before the financial crisis, but nothing like the $4.5 trillion it holds now.
"The Fed is going to continue to be a material player in the fixed-income market," said Mr. Clarida, who expects the balance sheet to stabilize around $2 trillion.
John Bellows, portfolio manager and research analyst with Western Asset Management Co., Pasadena, Calif., which runs $345 billion in fixed income, noted that when Fed officials talked about selling four years ago, his firm added bonds as yields rose.
Not this time
"We haven't had that opportunity this time" with lower yields, he said. "That's definitely been the hard question this year. We are overweight on Treasuries. It's been a good position, but it becomes harder and harder to hold," said Mr. Bellows. "There are a few ways to take some of the risk out of the portfolio," including selling longer bonds and buying shorter corporate ones.
He does see a possible downside risk from lower inflation, which Fed officials are watching closely. For now, "it makes a favorable environment for bonds. That's been very good for other risk assets. More liquidity ends up being good for markets," said Mr. Bellows.
James Athey, London-based senior investment manager with Aberdeen Asset Management, which manages $81.8 billion in fixed income, said that while the financial markets "have largely shrugged their shoulders" about the impending sell-off, "we are more focused on what's going on with the growth backdrop. If the Fed was winding down their balance sheet in an environment where growth was faltering, then we'd be concerned," said Mr. Athey. "We try to be as long term as we can. In this current environment, there is so much going on and all of it has the potential to change markets. We think it's a good environment for risky assets," he said.
Robert Tipp, managing director, chief investment strategist and head of global bonds at $653.6 billion PGIM Fixed Income, noted that during quantitative easing, "people deployed that cash into riskier assets. With QE in reverse starting later this year, "the amounts are not earth-shattering but they are big. It is going to force the markets to absorb something that rivals the size of the U.S. budget deficit," Mr. Tipp said.
It could cause a correction in the stock market or a widening of corporate bond spreads, he said. If that happens, "it may make us less positive on the margins" of corporate and emerging market sectors, Mr. Tipp said. For now, "as an institution, we don't have to change anything. It's not going to go elsewhere, and that's a negative for growth."
Paresh Upadhyaya, senior vice president, director of currency strategy and portfolio manager at Pioneer Investments in Boston, with $175.5 billion in fixed income, said that while the conventional wisdom holds that QE is negative for currency, and reversing that would be positive, "it's a zero-sum game" because markets have underpriced expectations for central bank tightening. He expects other central banks to tighten, with interest rate differentials starting to move against the dollar in favor of non-dollar currencies.
Mr. Clarida of PIMCO expects to see large demand for currency in the intervening years of the wind-down.
Mr. Bartolini of T. Rowe Price is keeping his eye on global central bank assets, with the European Central Bank and Bank of Japan still adding to their balance sheets.
"Stimulative actions of other central banks provide the Fed some cover to renormalize policy, but with incrementally less liquidity in the system, the real test will be when the global economy is faced with an eventual shock. It may not be imminent, but we are in the later innings of the business cycle. This should flatten the curve, and we are focusing duration at the longer end," said Mr. Bartolini.
If there are signs that the economy is nearing stall speed, "you probably want to dial back some of the risk in your portfolio. Currently we like shorter-maturity assets such as ABS to play defense and bank loans for their relatively high spread," he said.
Jay Hatfield, president of Infrastructure Capital Advisors LLC, an actively managed ETF and hedge fund manager, worries about the potential for recession by 2019.
More pension funds purchasing longer-term Treasuries has depressed yields at that end of the curve. That fact, combined with predicted short-term interest rate hikes to the 3% mark around 2019, could create an inverted yield curve, which usually predicts a recession, he said.
Still, he shares the opinion the Fed unwinding will not be material as it proceeds over the next five years.
"There are $38 trillion in pension assets in the world now, and the U.S. is second-highest. So, we believe that the Fed selling long-term bonds is relatively small compared to that $38 trillion. At a minimum, pension funds would be big buyers of Treasuries in a sell-off."
To the extent that stocks have done well and they can lock in future returns, pension funds might switch to longer-term bonds, said Scott Jacobson, director of investment strategy at Hirtle Callaghan & Co., Philadelphia, who calls it "more of a math trade than an economic decision."
While the Fed officials "are just lowering the spillway a little bit, investment managers are looking at the shape of the curve. You'd rather not buy bonds until tightening is priced in. When you move on bonds depends on how you interpret the Fed," said Mr. Jacobson.
Bret Barker, specialist portfolio manager for Treasuries at TCW in Los Angeles, which manages $160 billion in fixed income, thinks that with valuations stretched, "risk assets are going to be under pressure" and his firm is watching the business cycle. "We just know we are in later innings of the game. It's very fluid," he said.
3 distinct cohorts
Late in the asset cycle, bonds organize themselves into three distinct cohorts that Tad Rivelle, TCW chief investment officer for fixed income, calls the safe, the breakable, and the bendable.
Safe assets like Treasuries and agency MBS help tamp volatility. Selling in favor of higher-yielding opportunities calls for breakable assets, which currently are energy and commodities but could spread to high yield and emerging markets. Bendable assets like investment-grade corporates and top-rated CMBS and ABS will suffer volatility but can survive a deleveraging cycle, he said.
Lisa Hornby on Schroders fixed-income team in New York, thinks that valuations have to adjust.
“My view is that central bank liquidity has been the underpinning of valuations. You've had central banks push people out the risk spectrum further. For us, that's going have ramifications. For us, it's a period of derisking. The price of assets is not compelling," Ms. Hornby said.