In the next month, the Federal Reserve will begin doing something it has never done before, and it could play a role in long-term interest rates trending higher.

As announced in its September 20 statement, the Fed will begin reducing or “rolling off” its balance sheet beginning in October. The reason this has never been done before is that, nine years ago, the Fed also began doing something it had never done before.

In December of 2008, in response to the global financial crises and onset on the Great Recession, the Fed embarked upon a mode of monetary policy that had previously never been enacted in the history of our nation. This was Quantitative Easing (QE), or as it can be practically described, the open market purchasing of billions of dollars in bonds on a monthly basis (which accumulated to trillions in aggregate) in an effort to reduce long-term rates, inject liquidity into the financial markets, and encourage shell-shocked investors to once again take on some level of risk in their portfolios. These QE policies were implemented in three separate programs (QE1, QE2, and QE3), which encompassed a total of about 4½ years at various points from 2008 – 2014.

While there remains a great deal of debate as to the ultimate effect, if any, that QE had on the overall economy, the overwhelming consensus is that it did help to push long-term interest rates lower amidst an environment of zero short-term rates. This can be seen in the decline on the 10-year Treasury yield, which fell from 4.00% at the beginning of November 2008 to 2.35% when QE3 concluded in November of 2014.

When the final numbers were tallied, the Fed had purchased close to $4 trillion in Treasury and Mortgage bonds. When combined with its previous holdings, the bond purchases drove the Fed’s balance sheet up to about $4.5 trillion. Here’s the interesting part: The Fed still owns those bonds. Moreover, in all the years since QE was first initiated, which includes the three years since it ended, the Fed has been reinvesting maturing principal back into these bonds. As a result, even though QE has been in the rearview mirror since 2014, the Fed has remained a huge net buyer of bonds – to the tune of about $500 billion annually.

At its June meeting, the Fed released an addendum to its statement (“Addendum to the Policy Normalization Principles and Plans”) announcing its intentions to reverse this ongoing reinvestment of maturing bond principal. While Fed officials did not provide a date at that time, they stated that a gradual reduction (non-reinvestment) of $10 billion per month, escalating to $50 billion would “begin this year.” At this most recent September meeting, they replaced the words “this year” with October. So the time is now upon us.

Based on the anticipated pace of the roll off, the Fed will hit its maximum threshold of $50 billion at the beginning of 2019. That will likely also be the year that the Fed moves from a net buyer of bonds to a net liquidator. Also, at this pace, the Fed may potentially reduce its balance by approximate one-half, or about $2.25 trillion by the end of 2021. Given that the Fed has accumulated $4 trillion-plus since 2008, this is nothing to scoff at. In the past two weeks alone, the 10-year Treasury yield has risen from 2.03% to 2.27%.

So what does this mean for investors? We believe it is one more dynamic – and perhaps a quite meaningful one – that will tilt the playing field toward higher rates in the foreseeable future. While there is a credible argument that the Fed can achieve this potential reduction without necessarily pressuring rates higher, it certainly will not be a factor pressuring them lower. So this overall scenario we are facing, combined with the distinct probability we could see three or four interest rate hikes by the Fed between now and the end of 2018, we believe could result in the 10-year yield exceeding 3% in that time frame. We also believe there is a good chance the yield spread between 2-year and 10-year Treasury bonds (currently at .82%) could steepen considerably in the year or so ahead, which would also serve to potentially increase longer-term rates.

The silver lining in all of this: We believe, based in large part on current economic conditions and trends in corporate earnings, that higher interest rates are long overdue and will be good for our economy and the markets. They will likely provide momentum for the earnings of banks and other financial institutions, may allow investors the opportunity to once again pursue measurable returns on low-risk assets, and may provide much-needed income for the millions of retired or soon-to-retire senior citizens. These potential outcomes point to a strengthening economy, which should also be favorable for stocks over the long run.

The zero interest rate environment that began almost a decade ago, combined with the trillions in QE-induced bond buying and its continuous reinvestment, has in our opinion, run its course. It is time to move on. In other words, let’s roll. Roll off, that is.

About the author

Tom Wald is responsible for overseeing the investment and mutual fund product development functions and sub-adviser selection process. He also actively publicizes Transamerica’s investment thought leadership and products to advisors, clients, and the media. Tom has more than 25 years of investment experience and has managed large mutual funds and sub-advised separate account portfolios. Tom holds a bachelor’s degree in political science from Tulane University and an MBA in finance from the Wharton School at the University of Pennsylvania. He has earned the right to use the Chartered Financial Analyst (CFA) designation.Tom Wald, CFA® Chief Investment Officer, Transamerica Asset Management, Inc.

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