How could the Fed unloading bonds affect the bond market outlook?
The Federal Reserve Board is, of course, the U.S. central bank, which is granted unlimited purchasing power. In the past few years, the Fed has bought bonds at an unprecedented rate, to the extent that it now owns an extraordinary $8.7 trillion worth of bonds overall. This was done as a response to the massive economic downturn that the country experienced in 2008 and more recently, the recession caused by the pandemic.
The Fed purchased massive amounts of U.S. Treasury securities after this happened. It also purchased massive amounts of mortgage-backed securities from Freddie Mac and Fannie Mae. This helped to stabilize the housing market by making housing credit more readily available.
How has the Fed’s buying spree affected the bond market outlook?
This move has disrupted the normal market forces of supply and demand. When someone buys a bond, they want to get the highest return possible on their investment. Bids usually end up falling between greedy and less greedy buyers, with the end result being a fair price that falls a little bit over the current rate of inflation. This allows the buyer to gain a small profit over the cost of inflation.
The way that the Fed has been purchasing bonds, however, is by putting in bids that are far below what most investors are willing to accept. This has put the actual yield in bonds below 1.5% today, causing some economists to claim that the Fed is interfering with the natural workings of the marketplace. This is also changing the bond market outlook for regular investors.
What would happen to the bond market outlook if the U.S. central bank were to stop buying Treasuries altogether? It’s very possible that bond rates would increase from where they are today, to the point where investors would once again be earning a small return after inflation. If the Fed were to go further, and start selling some of its massive bond holdings, it would increase the market with bonds. This could potentially create a buyer’s market where the buyers could set the prices, driving rates even higher.
But how would that affect the bond market outlook?
The Fed unloading bonds would affect the bond market outlook in two ways:
- Decline of stocks — If investors could buy secure returns at a good rate, they might be motivated to shift at least some of their holdings from stock to bonds. That could trigger a decline in stock prices. It would create a new buyer’s market, where stock buyers can wait for stocks to drop to more attractive prices before jumping in to buy the dip.
- US government debt — The other impact would be on the U.S. government debt, which currently stands at a record $28.43 trillion. If the government began paying 7% on that debt instead of 1.5%, the debt service could become a much larger expense for the government. This could lead to higher tax rates for Americans.
Federal Reserve Board economists are highly aware of the potential impact on the government’s debt and investment markets. The most recent announcement unveiled plans to scale back purchases by $30 billion a month. It’s probably going to take a very long time to unwind an $8 trillion balance sheet, but it’s not out of the question that even a modest step in that direction may cause some bond and stock market turbulence.
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