Unwinding The Fed, And Your Bond Fund

When the Federal Reserve stops paying an extra penny for every bond and mortgage backed security out there, what happens to the bond market? For RIAs dealing with long term clients, this may not look like a pressing issue. But when you consider that traders will be repricing fixed income assets as bond spreads widen from an eventual Fed exit again, then advisors will have antsy clients wondering why their old faithfully stable bond funds are bouncing around all over the place.

Here’s what’s happening on the Fed side.

First off, the possibility of another taper was highlighted in last Wednesday’s FOMC minutes. Fed Chairwoman Janet Yellen speaks on Monday so we may have a better idea of what they are thinking over there.

As it now stands, the Fed balance sheet stands at $4.5 trillion, or about 25% of GDP, compared with a balance sheet of $800 billion prior to the financial crisis. The increase in the size of the balance sheet largely reflects the impact of the Fed’s bond and derivatives purchasing program that began back in October of 2008 under the Toxic Assets Relief Program. The Fed now holds the world’s biggest bond fund, with a reported $2.5 trillion worth of Treasuries and $1.7 trillion of government-guaranteed mortgage backed securities from Fannie and Freddie and the rest of those TARP assets the Fed has been buying from the likes of AIG and others for the past seven years. On the liability side of the Fed’s balance sheet, the largest category is bank reserves — deposits that commercial banks hold at the Fed. These are the corresponding element of the Fed’s purchases of bonds in its QE programs. Banks which hold these reserves are paid an interest rate, which some financial pundits have argued amounts to a significant subsidy for the banks.

So far, the Fed hasn’t really touched its balance sheet and has only reinvested the proceeds of its bond portfolio into more of the same, notes Neil MacKinnon, an economist with VTB Capital in London. Within the Fed, the debate over the unwinding of its balance sheet seems to have moved towards a point where, after recent increases in the fed funds target range, the Fed is more confident about gradually reducing the size of its balance sheet, he says.

“The key word is ‘gradually’,” MacKinnon notes.

The Fed is more than aware about the possibility of taper tantrum effects in the bond market and so therefore is unlikely to do anything aggressively that generates unwanted market volatility. If all goes according to plan, bond funds won’t get clobbered by the Fed. But if they do, at least fund managers will have someone to blame.