Saturday, May 04, 2013

the beginning of the end of QE (what happens?)

The Fed met again April 30-May 1 and as expected, kept interest rate policy unchanged. But the recent debate at the Fed has focused less on interest rates and more on when to begin reducing its bond purchases from the current pace of $85 billion per month. A few Fed members have indicated that they would like to taper down purchases later this year. What does that mean for the bond market?

A steeper yield curve is likely. When the Fed signals a slowdown in bond purchases it could trigger higher long-term interest rates and a steepening yield curve, in our view. Since the Fed has concentrated its bond buying in long-term debt, less buying would mean that private sector buyers would need to step in to fill the gap. It's likely they would demand higher interest rates than the Fed. Also, presumably the Fed will begin tapering its purchases when they are confident that the economy is a on a sustainable path to stronger growth and lower unemployment. Those factors are likely to push long-term interest rates higher as well. However, based on the latest projections by the Fed, most members see short-term interest rates to remain near zero until 2016. Consequently, we anticipate that the yield curve will steepen with short-term rates remaining anchored at low levels while long-term interest rates move higher.

Bottom line. The Fed could begin to signal that they are going to reduce the pace of monthly bond purchases later this year. We would expect that long-term interest rates are likely to move higher and the yield curve to steepen, in response to that signal. Although we don't expect a sharp rise in interest rates, we suggest preparing for a steeper yield curve by limiting your exposure to long-term bonds.

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