The Federal Reserve's Take on Bonds

Rodney Johnson |

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After the last meeting of the Federal Reserve, Chair Janet Yellen announced that the committee voted to lower its bond buying from $25 billion to $15 billion per month, and then cease bond buying altogether after October.

Depending on how you look at it, this brings an end to a program that has either been hailed as a great success or reviled as the biggest theft in American history. Either way, most people have come to the logical conclusion that if the Fed is no longer buying bonds, then interest rates will naturally rise.

The problem is… it’s not true. The Fed’s purchasing of bonds is far from over.

The statement by Yellen about the end of bond buying applied to the committee’s latest attempt to turn the economic tide by forcing down long-term interest rates through a program of printing new dollars to buy medium and long-term bonds. This program known as Quantitative Easing 3 (QE3) has been part of our lives since December of 2012.

In the intervening months, the Fed has purchased well over one trillion dollars’ worth of bonds and clearly held down interest rates from what the market would’ve been.

In December of last year, the Fed announced plans to reduce the rate of its bond purchases under QE3 at each successive meeting with one specific goal in mind: end the purchase of bonds entirely by October of this year.

It’s true that the Fed will stop adding to its bond portfolio in October. However, there’s the pesky issue of managing the roughly $4.2 trillion worth of bonds that the Federal Reserve now owns. These bonds have varied maturity dates so it’s fair to ask what the Fed intends to do as bonds pay off. Luckily, Yellen addressed that issue specifically.

In her statement after the last meeting, she said that the size of the Fed’s portfolio will remain intact at least until short-term rates begin to move higher, which she’d already stated would happen a “considerable time” after the end of QE3.

So bond buying, intended to increase the Fed’s holdings, will end in October and then short-term interest rates will remain near zero for a considerable time, which many analysts expect to be at least six to nine months.

The size of the Fed’s portfolio won’t drop before this, which means that the Fed must reinvest the proceeds when any of its current holdings mature or pay off early.

Early payoffs and maturing bonds can represent a substantial sum of money when you own $4.2 trillion dollars’ worth of securities.

The Fed’s recent report on holdings shows $1.1 trillion worth of bonds maturing in one to five years with a smattering of holdings that mature over the next several months. As to how many bonds will be called before they mature, that’s anyone’s guess.

For investors expecting to cash in on rising interest rates because the Fed’s about to be “out of the market,” they might have to wait a bit longer than October. And since growth rates in large, developed nations around the world keep disappointing, there might not be many other factors that will push rates higher in the near term.

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