Bond markets are bracing for a historic moment: the beginning of the end of easy Fed policy. What comes next is anyone’s guess.
The Federal Reserve is expected Wednesday to announce it will start unwinding the easy money policies that it has pursued since the financial crisis.
Many investors are taking the expected Fed action as a vote of confidence that the economy can grow without persistent support. They add that the Fed has signaled its intentions clearly enough that a disorderly debt-market decline similar to the 2013 “taper tantrum” appears unlikely.
Yet U.S. government debt prices have fallen for six-straight days, pushing up the yield for the benchmark 10-year U.S. Treasury note to 2.230% on Monday. Bond yields rise as prices fall.
The bond slump, the longest since March, reflects growing investor unease ahead of this week’s Fed meeting. Investors remain wary that any mistake by the central bank, such as removing stimulus too quickly, could upend months of relative calm. Conversely, if the Fed falls behind and allows inflation grow too quickly that could also put the economic expansion at risk.
Bond yields tend to rise in periods when the economy is surging, reflecting investors’ bets on continued growth. Yet in an economy dependent on consumer debt to finance purchases for everything from homes and cars to televisions, any policy that increases borrowing costs poses the risk of curbing the expansion.
The market’s ambivalence heading into Wednesday’s meeting highlights the stakes for the Fed and investors alike. The central bank has helped engineer a more-successful rebound from the financial crisis than many analysts would have thought possible. But at a time of near record stock indexes, bond yields far below Wall Street’s expectations at the start of the year and a declining dollar that continues to vex investors, the prospect of a textbook unwind of expansive monetary policy seems almost too good to believe.
“There’s always some risk that unwinding the balance sheet is going to be negative for risk assets,” said Vassili Serebriakov, a currency strategist at Crédit Agricole. “We know what the plan is, but it’s possible it has a different impact than what the market expects.”
In 2013, then-Fed chief Ben S. Bernanke’s indicated the central bank could soon end its quantitative-easing program. Treasury rates shot higher in what investors called the “taper tantrum” and the 10-year yield almost doubled to 3% by year-end.
Twenty-one percent of investors say a policy misstep by the Fed or the European Central Bank represents the biggest tail risk to the markets, according to a Bank of America Merrill Lynch survey conducted Sept. 1 to Sept. 7 of 214 investors with $629 billion in assets under management.
Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management, has shifted Treasury portfolios into shorter-term securities. He attributed his move to “expectations longer-term that yields are going to rise.”
Others worry about the impact of the Fed’s moves on a bull market in its ninth year. They warn the unwinding could gradually pressure stock valuations, which are often calculated relative to bond yields, as well as corporate earnings growth—a key driver of stocks’ gains this year. Utilities shares, often thought of as bondlike because of their relatively hefty dividends, are likely to underperform if yields rise, Goldman Sachs said.
Not all stocks would necessarily suffer. A rise in Treasury yields could benefit bank stocks by increasing the gap between what they pay on deposits and charge on loans, according to Goldman Sachs research.
The bond market’s reaction to Fed pullbacks suggests how difficult the task is. In four of five occasions when the central bank has ended or begun reducing a stimulus program since 2010, the yield on the benchmark 10-year Treasury note was lower three months later as the economy struggled.
More recently, investors dumped global government bonds this summer after comments from the European Central Bank, Bank of England and Bank of Canada fueled concerns that central banks around the world were looking to move away from less-accommodative monetary policy.
The Fed meeting could also prompt repositioning around the globe. A tick-up in inflation last week sparked new bets the central bank will raise interest rates in December, which many saw as unlikely at the start of the month.
Emerging-market assets, which have rallied this year in part due to the Fed’s cautious policy stance, are particularly vulnerable to tighter U.S. monetary policy.
Lower U.S. rates typically drive investors into emerging markets such as China and Mexico by making their bonds, stocks and currencies more attractive. Their dollar-denominated debts also become cheaper to pay back as the value of the U.S. currency falls, while the commodities that many developing nations export—often priced in dollars—become more affordable to international buyers.
The MSCI Emerging Market Currency Index has gained 9.3% this year through Friday, setting a fresh three-year high this month, as the dollar has tumbled 8.1% against a basket of major peers. MSCI’s index of emerging market stocks has soared 29% this year.