Bond Selloff Might Force Fed to Rethink Shedding Assets
Federal Reserve’s quantitative tightening is one of the factors pushing long-term rates higher
By Justin Lahart
Federal Reserve Board Chair Jerome Powell said last month that cutting rates and continuing to cut down the size of the balance sheet wouldn’t necessarily be inconsistent. PHOTO: CHIP SOMODEVILLA/GETTY IMAGESLong-term interest rates have shot much higher in not much time.
The tens of billions of dollars of Treasurys and mortgages the Federal Reserve is effectively pushing onto the market can’t be helping.
The yield on the 10-year Treasury note was 4.74% on Wednesday, which compared with 3.84% on June 30.
The average rate on a 30-year mortgage has risen to about 7.9%, according to Bankrate.com, from 7.2% at the end of June.
The result is a stiffening of financial conditions that the economy must fight through even as it faces a series of new hurdles.
These include ongoing strikes against Detroit automakers, the resumption of student-debt payments and the continuing possibility of a government shutdown.
This latest jump in long-term rates has occurred even as the Fed’s tightening campaign appears to have come to a close, with futures markets putting the chances of a further rate increase this year at only about one in three.
One reason is that Fed policy makers have been working hard to convince markets that an end to rate increases won’t be a prelude to immediate cuts.
They have also made clear that they don’t intend to stop reducing the pile of Treasury and mortgage securities the central bank amassed in its earlier efforts to boost the economy.
In the “quantitative tightening” program that the Fed kicked off last year, it is currently allowing up to $60 billion in Treasurys and $35 billion in mortgage-backed and agency securities to mature each month without replacing them, effectively adding to the supply of bonds that other buyers must absorb.
That in turn puts downward pressure on securities prices and upward pressure on rates.
The Fed thinks its current securities portfolio is far too big at over $7 trillion and isn’t inclined to stop shrinking it.
The surest signal of this came in early July, when Federal Reserve Bank of Dallas President Lorie Logan said she was surprised that investors seemed to think that as soon as the Fed started to lower interest rates it would also stop reducing the size of its balance sheet.
Her comments carried weight: Before joining the Dallas Fed last year, Logan worked at the New York Fed, managing the Fed’s massive security portfolio.
Following the Fed’s policy meeting later that month, Fed Chair Jerome Powell said that depending on the circumstances, cutting rates and continuing to cut down the size of the balance sheet wouldn’t be inconsistent.
The Fed’s reasoning is that its current 5.25% to 5.5% target range on overnight rates looks quite restrictive relative to where it would be if inflation and the job market were where the central bank wants them.
Viewed this way, lowering rates would merely make them less restrictive, akin to slowly easing off the brakes.
So cutting rates wouldn’t be at cross-purposes with continuing to shrink the balance sheet.
Seth Carpenter, a former Fed staffer who is now Morgan Stanley’s chief global economist, has long held the view the Fed would aim to continue quantitative tightening.
The firm’s economists forecast the Fed will start cutting rates from the current level in March, but that it won’t start to reduce the amount of securities it is letting run off its portfolio until sometime in the latter half of next year.
The Fed, however, could be underestimating what its commitment to quantitative tightening is doing to market psychology.
This is particularly the case with mortgages: Not only is the Fed reducing its holdings, but big banks, focused on overcoming the effects of rising interest rates, have been less eager to buy.
Mortgage rates are much higher relative to Treasury yields than has historically been the case, magnifying stresses on the housing market.
The Fed might like investors to view quantitative tightening as something that is mostly happening in the background, but investors might not be inclined to agree.
Something similar has happened before, after all.
In 2013, the Fed was preparing to taper the pace at which it was accumulating assets, which to its view would still have still been effective easing.
Then-Chairman Ben Bernanke said this would “be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes.”
Markets thought differently, and after the so-called taper tantrum pushed long-term rates sharply higher, the Fed went back on its plans.
In December 2018, Powell unsettled already-rattled investors when he said the quantitative tightening program the central bank then had in place was “on automatic pilot.”
The following month he walked back that notion.
The surest way for the Fed to stop long-term interest rates from screeching higher would be for it to first take the possibility of another rate increase this year off the table.
If that doesn’t work, it might need to not just raise the possibility of cutting rates, but also signal that it is open to dialing back quantitative tightening.
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