The Federal Reserve’s balance sheet has more than tripled, to more than $3 trillion, since the 2008 global financial crisis as a result of large scale asset purchases — quantitative easing (QE) — meant to help prop up the U.S. economy. Given such unprecedented stimulus, the path to normalization likely will be just as unprecedented. Ever since the Fed began the extraordinarily accommodative monetary policies, they have publicized the means they expect eventually to use to dry up the massive liquidity they have created. Such measures include selling, or “repo-ing,” securities back to the banks from which they bought them, allowing securities to mature without reinvesting the proceeds, and increasing the interest the Fed now pays to banks on funds held in reserve accounts (currently 0.25%) to discourage banks from relending those funds to business and households. The question is not “if” but “when” they will start to unwind the holdings on their balance sheet.
Recent Federal Open Market Committee meeting minutes suggest that, in the face of an improving economy, Fed officials are closely evaluating the costs and benefits of sustaining this QE. According to the minutes, “many” committee members have reservations over the current open-ended commitment to buy $85 billion worth of assets every month. But, in his recent Humphrey Hawkins testimony to Congress, Fed Chairman Bernanke reiterated the Fed’s commitment to continue asset purchases and maintain low rates “until it observes a substantial improvement in the outlook for the labor market.”1 This suggests that normalization of policy may be on the, albeit still very distant, horizon.
What does this mean for investors? For now, as a result of Fed actions, rates remain near historic lows and financial repression continues. We believe this environment favors equities. If you have to own bonds, you should think about going beyond traditional fixed income and consider investing in securities that may provide a cushion, in terms of yield, against the eventuality of rising rates. Such securities could include senior loans and high yield bonds, which have historically performed well in rising rate environments.2 Note that past performance does not guarantee future results.
- Source: Chairman Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., 2/26/13.
- Source: Bloomberg, 2/28/13. Past performance does not guarantee future results.
Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and the Fund’s share prices can fall. Senior loans are typically lower-rated (more at risk of default) and may be illiquid investments (which may not have a ready market). Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk.