The Fed hiked interest rates at their June meeting and provided details regarding an eventual shrinking of their balance sheet. Despite a growing backdrop of waning marginal monetary support, the second quarter saw strong gains across international developed and emerging market equities, as well as solid performance from high-quality fixed income sectors, while energy-related assets suffered.
Federal Reserve Hikes Rates at June Meeting
At their mid-June Federal Open Market Committee, the Federal Reserve moved forward with a 25 basis point increase to the federal funds rate, placing the new targeted range at 1.00%-1.25%, the fourth hike in the current tightening cycle. Of equal significance was the Fed’s detailed statement regarding plans for a partial winding down of their balance sheet, which, at over $4 trillion as of June 14, 2017, is more than five times the size it was before the Global Financial Crisis. Among other line items on the Fed’s balance sheet are more than $2 trillion in nominal Treasury securities, nearly half of which are set to mature in the next three years.
This “wall of maturities” has the potential to materially alter the Fed’s influence on broader financial conditions. Previously, the Fed replaced maturing bonds with newly-issued securities at auction, serving as a key support mechanism for financial conditions by creating demand for Treasuries and maintaining a large amount of the banking system reserves. In other words, despite a lack of direct asset purchases since the conclusion of the Fed’s third quantitative easing program in October 2014, the Fed has remained stimulative through the reinvestment of maturing securities.
Although the Fed provided some insight into their plans for shrinking the size of their balance sheet, any long-term implications for financial conditions, asset prices, and economic fundamentals remain difficult to discern. Declining demand for Treasury securities on behalf of the Fed may lead to rising Treasury rates, as previous Fed Treasury reinvestment's helped apply upward pressure to Treasury prices through the stripping of supply from the market; however, the combination of interest rate hikes and a shrinking balance sheet could conversely serve as a headwind to already elevated valuations across many “risky” areas of the market, potentially supporting safe-haven assets that typically benefit in a risk-off environment. To summarize, the ramifications of the Fed’s next chapter in their tightening playbook remain unclear, necessitating vigilance on the behalf of investors seeking to navigate the shifting winds of today’s central bank-dominated capital markets successfully.