Phil Milburn

This is what it sounds like when doves coo

Phil Milburn

Phil Milburn - This is what it sounds like when doves coo

At its March 2019 meeting, the Federal Open Market Committee (FOMC), the policy-setting arm of the US Federal Reserve, gave a very dovish outlook for interest rates.

The dot plots, which illustrate each member’s best estimates for future rates, were moved down so the FOMC now anticipates no rate rises in 2019 and only one in 2020. The bond market, at the time of writing, is now pricing in the next move actually being a cut in rates. 

The rate outlook has already garnered a lot of attention from the world of financial journalism, so I would like to focus on the other monetary policy development – the ending of QT (quantitative tightening).

What’s an odd $3 trillion between central bankers?

In September 2018, I wrote about the risk that the Fed undertook too much QT and made the markets scream.  It was always going to be noisy when QT came to a halt, but I didn’t expect it to be a cooing sound from a very dovish set of central bankers. 

Rather than running the system’s excess bank reserves down to zero, the Fed is going to settle for a figure in the $1.25 trillion ballpark. The following chart shows the outlook for the liability side of the Fed’s balance sheet:

federal reserve balance sheet liabilities  

Source: Liontrust, Bloomberg as at 22.03.19

Using the hashed areas, I have added stylised projections although there will clearly be volatility around this.  Additionally, over the long term, the balance sheet of central banks naturally grows as the quantity of money in circulation increases. What is clear is that the new level the Fed is choosing to maintain is a little above $3.5 trillion; over $3 trillion higher than the pre-financial crisis levels.

Not interfering in the credit process

The Fed would still like to remove all the mortgage-backed securities (MBS) from its balance sheet so that it is, to paraphrase, “not interfering in the credit allocation process”. The fact that maintaining the excess bank reserves is a deliberate strategy to help with monetary policy implementation and the credit transmission process is glossed over in this virtuous aim. 

Glossing over this contradiction, in May the Fed will reduce the monthly cap (the maximum that can be paid back via QT in any month) in US Treasuries from $30bn to $15bn. The cap on MBS remains unchanged at $20bn. In September 2019, QT will finish as the Fed stops shrinking its balance sheet. 

On an ongoing basis, the composition of the asset side of the balance sheet will thus evolve with up to $20bn MBS being repaid and replaced with US Treasuries every month.

federal reserve balance sheet assets

Source: Liontrust, Bloomberg, at 22.03.19

This projection, again smoothed for the sake of illustration, is shown in the graph above with the green hashed area (US Treasuries) taking balance sheet share from MBS (grey hashed).

How to make money out of this in fixed income markets

Jerome Powell, the Federal Reserve chair, has been clear he wants to run inflation “hot” for a while to illustrate its 2% target is symmetrical.  The Fed being so dovish is a dangerous thing for the longer term and risks higher inflation becoming embedded within the US economy. 

My colleague David Roberts has already written on this subject, which just leaves me to expand upon the three main actions we are taking in the Strategic Bond funds to aid performance in this environment.

First, as risks in the bond markets have increased, we have reduced portfolio beta. On the duration side of the equation, where the rally post the Fed’s dovishness has taken government bond markets firmly into overbought territory, we have reduced risk to approximately two years’ worth of duration exposure. 

Within credit, we have been taking profit after the strong risk rally this year and have less than 15% in high yield, with the bonds the Funds do own of higher quality than the generic market. Within investment grade, we have been rotating exposure into lower-volatility positions and prefer corporates to their financial cousins.  The premature ending of QT is undoubtedly helpful for emerging markets, but that is more than reflected in bond prices and we are happy to have zero exposure.

Moving from beta management to alpha strategies, we have built in some inflation protection to the portfolios. The Funds have approximately one year of their duration exposure emanating from Treasury Inflation Protected Securities. Furthermore, about 5% of the investment grade weighting is in US Floating Rate Notes, which benefit when rates rise.

Finally on the alpha front, we have US curve steepener positions on within the Funds. We have a strong preference for intermediate dated bonds with five to 10-year maturities; these will remain reasonably well anchored to US base interest rates, at least until Powell makes his next U-turn. 

However, longer-dated bonds with a 30-year maturity will bear the brunt of the dovishness and need more of a term premium to compensate for the risk their real value is eroded by higher inflation.

For a comprehensive list of common financial words and terms, see our glossary here.

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, March 26, 2019, 9:45 AM