Though the Federal Reserve raising rates this week was widely anticipated, the additional commentary on how they plan on reducing their $4 trillion bond position was not. In February 2017, I wrote an article (“Putting the Monetary Morphine Genie Back in the Bottle”), which forecasted that the Fed would have to start selling their holdings to unwind the many years of ultra-accommodative monetary policy. This week’s Fed guidance confirms it.
The market’s reaction has been even further yield spread tightening, which happens because many are buying short-term bonds over long-term ones. Get ready for more exciting yield curve drama in the second half 2017. Most importantly, I’m very concerned about a 1994 extreme tightening yield spread scenario developing (see chart below).
Over the next few weeks, the unwinding will begin. Roughly $10 billion per month will be sold for the first three months. Most selling will be of US Treasuries (60%), the balance will be mortgage-backed securities. Then, they’ll continue the pace, adding another $10 billion every three months thereafter, until they reach $50 billion per month. Umm…. WHOA!! This is extremely aggressive, considering how very dovish the Fed has been these past two years. This amount of selling pressure will mean public debt market prices shall be headed much lower, yields (which move inversely to prices) are now set to move higher.
Per my previously mentioned Feb’17 article, most of the Fed’s balance sheet is in maturities due within the next 5 years. This means the possibility of much higher short-term rates over long-term rates, would create a most dreaded inverted yield curve scenario. No one wants that, so I’d expect we’d see clever selling across long- and short-dated maturities to manage the yield curve shape.