The Federal Reserve (Fed) has a new leader, but its policy toward the bond market has not changed. That might seem a strange comment at a time when the Fed is reducing its purchases of Treasury notes and bonds and mortgage-backed securities. The tapering process has already cut those monthly purchases from $85 billion to $65 billion, and more reductions are likely in the months ahead. This process began when Mr. Bernanke was Fed Chairman, and it appears that Janet Yellen, the new chair, is not inclined to change it.
There appears to be a consensus that if the Fed is buying fewer notes and bonds, monetary policy must be less expansionary. That is, in my view, an incorrect interpretation of the Fed’s policy. The objective of the low federal funds rate and the various rounds of quantitative easing has been to keep bond yields low, which would keep mortgage rates and corporate bond yields low as well. By maintaining low borrowing costs for companies and homeowners/homebuyers, the Fed sought to promote a recovery in economic activity. The asset-purchase programs were an effort to prevent those borrowing costs from increasing and thereby slowing economic activity.
A shift in tactics, not a shift in policy
The primary reason the Federal Open Market Committee (FOMC) decided to scale back those purchases is that they felt the economy could now tolerate slightly higher bond yields. They are not, however, prepared to accept substantially higher bond yields. They feel that if they can convince investors that short-term rates are going to stay low for a long time into the future, bond yields will stay near current levels. In view of her comments last week, Fed Chair Yellen and most of the FOMC believe that the economy still needs low bond yields.
Thus, the reduction in asset purchases should be viewed as a shift in tactics, not a change in the Fed’s policy objective. Forward guidance is replacing quantitative easing as the primary tactic for keeping bond yields near current levels.
For now, forward guidance appears to be working. Auctions of 10- and 30-year Treasuries last week drew good demand, especially from overseas. Unsettled conditions in the global markets usually boost foreign demand, so the strength of that demand without the flight-to-safety bid has yet to be determined.
Three pillars of support for bond prices
There are good reasons to expect that the Fed’s promise to keep the federal funds rate near zero should help sustain domestic and foreign demand for notes and bonds:
- Global economic growth has shifted lower in recent months, apparently reducing inflation expectations. That, in turn, has reduced the perceived risk of owning longer-maturity notes and bonds.
- A federal funds rate near zero has helped create and sustain exceptionally steep yield curves, and steep curves are another incentive to own the longer maturities. There is considerable incremental income to be gained from even moderate maturity extension, and in a low-yield era, that additional income can be the difference between above-average and below-average total returns. And, as I have argued in earlier posts, steep yield curves act to reduce the negative impact on bond yields and bond prices of a cyclical increase in short-term rates.
- Fewer Treasury notes and bonds are being issued. The federal deficit has shrunk from as large as $1.3 trillion in 2011–2012 to less than $600 billion this fiscal year. Such a large reduction in new-issue supply is an important offset to a gradual reduction in purchases by the Fed.
Fed policy and fundamentals point to low yields in 2014
The Fed’s tapering of its asset purchases is a change in tactics, not a change in its policy of monetary accommodation. The primary policy objective remains to promote economic growth by keeping bond yields low. The tactics to achieve that objective are shifting away from quantitative easing toward what the FOMC calls forward guidance. To be sure, there is no guarantee that this shift in tactics will be successful in keeping bond yields near current levels. But, other fundamentals that influence bond yields, such as moderate global economic growth, low global inflation, steep yield curves, and smaller federal deficits, are likely to assist the Fed in keeping market yields relatively low in 2014.