The Federal Reserve: How the play ends
The unprecedented expansion of the Federal Reserve’s‡ (Fed) balance sheet that has occurred via quantitative easing‡ (QE) over the last few years has created anxiety over the challenges associated with normalizing the Fed’s investment holdings. Forecasts about how the Fed will shrink its balance sheet by “managing down” its portfolio, a process loosely referred to as the Fed Exit Plan, have ranged from moderate concern to outright panic.
Recently, the Federal Reserve provided an ambiguous update on its QE3 program, with Chairman Ben Bernanke supporting ongoing stimulus efforts during his testimony‡ at a Congressional hearing. That was followed later the same day with the Fed’s April meeting minutes showing some officials would like to begin slowing the program as early as next month.
Regardless of exact timing, if the Fed successfully orchestrates a relatively smooth transition out of QE and into a tightening phase, we believe:
- The next two to three years of Gross Domestic Product GDP‡ growth will be 2.0-2.5 percent and that interest rates will move to 2.5 percent in 2013 and 3.5 percent in 2014.
- The Fed Exit period will be marked by bouts of short-term volatility, but over the longer cycle should not result in dramatic, uncontrolled spikes in interest rates.
- This environment should be supportive of positive equity returns and will be punitive for fixed-income assets‡, especially longer-duration government bonds.
- This should help spreads on corporate and mortgage-backed security (MBS)‡ assets continue to grind tighter as the cycle unfolds.
Click here to read my full perspective on the Fed Exit Plan.
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Mr. Kelley is managing director of fixed income at UMB and is responsible for overseeing the product development and management of the fixed income holdings for the Wealth Management division. Mr. Kelley earned a Master’s of Business Administration from Baker University in Kansas City.