Prison » The Fed Takes Full Control Of The Bond Market

Thorstein Polleit
The Mises Institute
March 5, 2019

The US Federal Reserve (Fed) has signalled to financial markets that it wants to pause further monetary policy tightening for some time. Investors, however, take a somewhat different view of what the Fed is going to do: They assume that the Fed’s interest rates hiking cycle has come to an end. This is pretty bad news for holders of cash, savings deposits and bonds: It means that inflation-adjusted US interest rates will – if price inflation remains at current levels – remain zero or even in negative territory.

By no means less important is the Fed’s new plan to put an end to its balance sheet shrinking in the coming months. In this context, we have to remind ourselves that the Fed started buying government and mortgage bonds in the course of the financial and economic crisis 2008/2009. As a result, the Fed’s balance sheet expanded from 870.3 US$bn in September 2007 to a record 4.489,3 US$bn in November 2015. In October 2017, however, the Fed decided to throw its crises-era bond purchase program into reverse.

Since then, the Fed let its balance sheet shrink to 4.039.7 US$bn in February 2019 – mainly by allowing bonds to mature each month and not reinvesting the redemptions in the market place. Even if the balance sheet shrinking were to end soon, however, the Fed would remain in charge of a pretty sizable fixed income portfolio and would have to keep reinvesting significant amounts of money on a regular basis. In fact, it would remain a big buy-side player, exerting permanent downward pressure on market interest rates.

The Fed’s overpowering impact on short-term as well as long-term market interest rates would be cemented. It may not even be an exaggeration to say that the Fed is about to become the “master of the yield curve”. Looking ahead, it seems that credit market yields will be influenced predominantly by what…

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