For nearly a decade, quantitative easing (QE) has been a significant driver of capital markets. Born in March 2009 as a response to the great 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 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 for 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 an acute influx of bonds into the 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, both in terms of 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 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 bond market. The U.S. Aggregate Bond Index serves that purpose well.
Defining the market
Of course, markets aren’t static, and as the market’s composition changes, the index’s composition will change to reflect the market. Specific to the U.S. Treasury sector, the weight in the U.S. Aggregate Bond Index is 37%, 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 how the weightings ebb and flow, the U.S. Aggregate Bond Index is by definition the market.
Source: Bloomberg Barclays.
To summarize, QE is slowly dying out and it will hopefully be remembered as a historical curiosity. In the meantime, investors 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 market can surprise us. It has a way of humbling even the savviest prognosticators. Fortunately we can say for sure that keeping costs to a minimum, and sticking to your long-term asset allocation are crucial ingredients for success.
- All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.