Could a more aggressive Fed bring about ETF inflows?

The Federal Open Market Committee's recent turn toward battling inflation has set up spectacular, but not unexpected, declines for longer-dated U.S. Treasuries and agency mortgage-backed securities. This more aggressive stance for short-term interest rates and a purposeful reduction of the Federal Reserve balance sheet will attempt to unwind two years of pandemic-induced monetary policy.

Despite the despair across the yield curve, exchange-traded fund investors have continued apace into products holding U.S. government and agency securities. According to data from CFRA Research, 106 ETFs investing primarily in U.S. Treasury securities, including Treasury inflation-protected securities, and agency debt and MBS have taken in $34.4 billion this year. The inflows account for nearly 10% of total assets under management of $371 billion for these ETFs as of May 13.

Yet ETF participation in U.S. government and agency markets is paltry compared with the total outstanding issuance of $36.2 trillion at the end of 2021, according to data published by the Securities Industry and Financial Markets Association. Could more aggressive action by the Fed regarding its $8.4 trillion in domestic fixed-income securities end up funneling more assets into these ETFs?

On May 4, the FOMC put numbers behind a prior announcement to reduce its securities holdings. The Fed said it would both let holdings mature and curtail reinvestment. For June, July and August, the Fed would let $30 billion in Treasury securities run off while reinvesting any principal repayment above that threshold. After August, the runoff will jump to $60 billion per month. As of May 11, the System Open Market Account held $5.7 trillion in Treasuries. For agency debt and MBS, those monthly reductions are $17.5 billion and $35 billion, respectively, against a $2.7 trillion portfolio.

The FOMC statement was intentionally vague about where the runoff would settle. It also left the door open for more action.

"The Committee is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments," the statement said.

Should the Fed decide to actively sell into the market, ETFs stand ready to take in those assets. While it's highly unlikely that the Fed would pack up its bonds and fund an ETF (as Hong Kong's central bank did for equities acquired during the Asian financial crisis), the Fed's current holdings line up nicely for an authorized participant to take down scores of Treasury and agency securities at a time and shuttle them into a waiting ETF.

"The presence of ETFs enhances the likelihood that all goes smoothly (should the Fed decide to sell)," said Dave Nadig, financial futurist at ETF Trends. "More participants in the fixed-income market means more outlets for liquidity," he said.

In fact, the intraday liquidity and the availability of offsetting derivatives could make ETFs an ideal vehicle for price discovery, even in such deep markets, Mr. Nadig said. Fixed-income ETFs are a "time shock absorber" for potentially large sales, he said.

While other central banks have utilized ETFs over the past decade to enact policy — the Bank of Japan holds 80% of that country's equity ETFs, or 7% of the stock market, according to Bloomberg News — the U.S. central bank only warmed up to ETFs two years ago. Pandemic market dislocation ushered in the Secondary Market Corporate Credit Facility, which bought corporate investment-grade and high-yield ETFs to provide credit support to a wide array of businesses in one fell swoop. That program, which also bought individual bonds, was wound down in the fall of 2021.

Should the Fed need it, "there's a lot of liquidity in the belly of the curve," said Harley Bassman, managing partner at Simplify Asset Management Inc. Simplify manages $1.4 billion in ETFs, many of which utilize derivatives on interest rates and the Cboe Volatility index, or VIX, to enhance core exposures to stocks and bonds. "It's a public policy good to have a steeper curve with higher long-term rates," said Mr. Bassman, implying that a flat or inverted yield curve is highly disruptive to financial services firms, particularly insurers.

Elya Schwartzman, co-founder and chief investment officer at BondBloxx Investment Management LLC, on the other hand, doesn't currently see a scenario where the Fed would need to be more aggressive than jawboning and pushing on the federal funds rate. "There are no kinks in the curve," he said. BondBloxx manages a suite of seven high-yield sector ETFs with assets of $37 million.

While inflation expectations remain high, Mr. Schwartzman is watching particular slices of the futures markets. Specifically, he's looking at where traders see rates on 2-year and 5-year Treasury notes in two years and five years, respectively.

"The implied outlook for rates has come down," he said.