For nearly a decade, quantitative easing (QE) has been a significant driver of capital markets. Born in March 2009 as a response to the global financial crisis, QE loomed large in the minds of investors as the Federal Reserve vacuumed up U.S. Treasury bonds and mortgage-backed securities. The Fed’s balance sheet ultimately swelled from about $1.0 trillion to $4.5 trillion. But as the saying goes, all good(?) things must come to an end. Federal Reserve Chair Janet Yellen made it official in September 2017 that the time had come to pay our final respects to QE.
This policy shift leads to a couple of questions:
- What are the ramifications of the end of QE for bond yields?
- What does the end of QE mean for the composition of fixed income benchmarks?
Before jumping into the answers, or at least my best guess of the answers, it’s important to understand how QE will fade away. The key words to remember are gradually and passively. Gradually is pretty self-explanatory—a little bit at a time. We say passively because the Fed isn’t looking to sell securities from its balance sheet; instead, it just won’t replace a portion of the securities when they mature.
Will bond investors mourn the end of QE?
Now let’s get back to the question of bond yields and how they may react to QE’s end. Since the Fed isn’t selling securities, there won’t be a large influx of bonds into the fixed income market looking for a home. Instead, we should expect to see a more gradual uptick in fixed income supply as the buyer base loses a very large player.
To describe how the market may react to this change in supply and demand, I’ll throw out another key word: predictable. The Fed has taken a measured approach to removing accommodative monetary policy, in terms of both interest rate hikes and now QE. The market’s forward-looking nature and the fact that the Fed has been clear about the plan to end QE suggest that current interest rates are reflective of the market’s collective view of a post-QE world. In other words, unless the Fed significantly deviates from its stated course, we should expect to follow the path of rates that is currently priced into the market.
How will this affect bond benchmarks?
As for what this means for the composition of fixed income benchmarks, the answer is more concrete. The Bloomberg Barclays indexes remove the U.S. Treasuries held by the Fed from the amount reflected in the index. Vanguard has taken this best practice of “float adjustment” a step further and, since 2010, has followed versions of the Bloomberg Barclays indexes that also adjust for mortgage-backed and U.S. agency securities held by the Fed. Given this dynamic, QE’s unwinding will mean that for a given amount of Treasury or mortgage-backed issuance, a greater portion will now be represented in the benchmark. All things being equal, this will gradually raise the weight of these government securities and reduce the weight of nongovernment securities in multisector benchmarks such as the Bloomberg Barclays U.S. Aggregate Bond Index.
This brings up one last question. If the weight of government securities will likely increase, is the U.S. Aggregate Bond Index still an appropriate benchmark for the fixed income market?
Absolutely! If you believe in the case for indexing, then what you want from your benchmark is the broadest representation of the investable market—in this case the investment-grade, taxable U.S. bond market. The U.S. Aggregate Bond Index serves that purpose well.
Defining the market
Of course, the market isn’t static and as the market’s composition changes, the index’s composition will change. Specific to the U.S. Treasury sector, the weight in the U.S. Aggregate Bond Index was 37% as of November 28, 2017, which is slightly higher than the long-term average of 32% and about equidistant between the maximum weight of 50% reached in 1986 and the minimum weight of 21% observed in 2002. Regardless of how the weights ebb and flow, the U.S. Aggregate Bond Index is by definition the market.
Percentage of U.S. Treasuries in the Bloomberg Barclays U.S. Aggregate Bond Index
Source: Bloomberg Barclays.
To summarize, QE is slowly dying out and it will hopefully be remembered as a historical curiosity. In the meantime, you and your clients should take comfort in the combination of the market’s efficiency and the Federal Reserve’s deliberate approach.
Given these observations, we should remember that, like life, the financial markets can surprise us. They have a way of humbling even the savviest prognosticators. Fortunately, we can say for sure that keeping costs to a minimum and sticking to long-term asset allocations are crucial ingredients for you and your clients’ success.