Managing Risk Exposures Amid Fed Balance Sheet Normalization


April 7, 2017 [U.S. Federal Reserve, Raising rates, Risk]
Josh Yafa

As the Fed raises rates and suggests it may start shrinking its balance sheet later this year, managing duration risk becomes much less straight forward.


The U.S. Federal Reserve has released the minutes from its March monetary policy meeting, suggesting that the unwinding of trillions of dollars in debt on its balance sheet could start later this year. The Fed’s bond purchases in the wake of the Financial Crisis resulted in its balance sheet expanding to approximately $4.5 trillion and were meant to create looser monetary conditions to stimulate the economy. As the Fed’s dual employment and inflation mandates have largely been met, the central bank is now slowly tightening liquidity to avoid an inflationary overshoot. So far it has raised its key Federal funds rate three times, and it appears that shrinking its balance sheet is also coming down the pike. But if the economy starts to soften and the yield curve begins to back up after the Fed also stops reinvesting proceeds from its maturing bonds, U.S. government bond funds with shorter duration, or less interest rate risk, will likely be fairly insulated and defensive. Yet a narrow focus on low duration may be short-sighted.

It’s important to look beyond duration toward the second-order effects, which could be more impactful. Much depends on how the Fed calibrates its tightening cycle with both the rate hikes and balance sheet contraction. If it moves too fast on both and causes economic softness to ensue, government bonds should benefit as they typically perform well during economic slowdowns. While it is not possible to predict the net effect, it’s reasonable to expect limited term government bond funds to prove resilient.

Nonetheless, we believe it is extremely important to balance risk exposures. While many investors focus tightly on duration given potentially higher rates, it’s also the case that those higher rates could serve as a significant headwind to the economy. Somewhat ironically, that would make longer-term, defensive bonds with some duration exposure more attractive, as they can soften the blow of an economic slowdown. So, in our view, it makes the most sense to create a robust portfolio that can perform across multiple macro outcomes. While we currently favor the lower end of our historical duration ranges, we still retain longer-term positions, given the dynamic outlined above.


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