No bell bottoms, miniskirts and rock and roll for bonds this quarter, although returns were positive. Those returns were well received given the drumbeat coming from the Federal Reserve. Increasing interest rates and reducing other stimulus continued to be hot topics in the Fed’s meetings.
More specifically, the Fed increased the target rate for lending between banks and said that they believe one more increase will be made before year-end. This was consistent with market expectations and appears to have already been priced into bonds.
In addition, the Fed also announced their plan for decreasing their balance sheet. As you will recall from previous letters, the Fed aggressively bought bonds during the downturn (what was referred to as Quantitative Easing). Those bonds ballooned the Fed’s holdings from about $800 billion in 2008 to about $4.4 trillion today. The issue now isn’t so much the size of those holdings but the changes in them going forward.
Rapidly reducing the holdings by selling the bonds back to the banks they came from could pull too much money out of the economy too fast. Instead, the Fed has decided to just let the bonds mature without replacing them. The Fed actually stopped buying bonds a few years ago, but as the bonds it held matured, they would replace them by buying new bonds and that action will now stop. What this means is there will be a very gradual reduction of the bonds the Fed holds and they firmly believe that will happen quietly in the background with minimal effect on economic growth.