Fed to Reduce Bond Holdings, Setting Stage for Higher Mortgage Rates

Fed to Reduce Bond Holdings, Setting Stage for Higher Mortgage Rates”

The limit on reinvestment is scheduled to increase by $10 billion every three months to a maximum of $50 billion per month until the central bank's overall balance sheet falls by perhaps $1 trillion or more in the coming years.

The Fed left rates unchanged for now, as was widely anticipated, but investors' expectations changed for December after the USA central bank signaled one more rate hike by year-end despite recent weak inflation readings. They have been pulled back from their all-time highs as investors assessed the Federal Reserve's policy statement, which indicated at increasing interest rates for the third time this year.

"They only gave passing mention to inflation outside of assuming that it will return to the 2% level in the medium term", wrote Ian Lyngen and Aaron Kohli of BMO Capital Markets. Rising U.S. Treasury yields boosted financial stocks, as higher interest rates tend to lift bank profits, but rate-sensitive sectors such as utilities were the weakest.

Financial stocks have been on a tear in recent days as investors anticipated Fed commentary on rate hikes, which tend to help bank profits. "There's still no reason to believe that stronger economic growth, the tightening labor market, eventual acceleration in wages wouldn't lead to some upward pressure on prices".

Nicholas Wall, portfolio manager of the Old Mutual Strategic Absolute Return Bond fund, said the move should not derail the economy: "This was widely expected; the Fed had wanted to get the process of balance sheet reduction underway before its composition changes next year".

Inflation data remains pivotal for the Fed policy framework but is expected to rise only gradually.

Other markets, however, are acting like this is a policy mistake.

"Indeed, based on the Fed's current plans, the balance sheet would still be as large as $US3 trillion in four years' time."
So, the Fed is doing it very slowly and carefully. "But we don't know for sure".

"The Fed's forecasts imply the bank is unwilling to freeze interest rates in an experiment to see how low unemployment can go without stoking inflation", MarketWatch said.

The markets' highlight of the week is the Federal Reserve's Open Market Committee (FOMC) meeting that begins Tuesday morning and ends Wednesday afternoon with a statement.

The Fed has felt confident to raise rates because it appears to have met one of its key mandates: maximizing employment.

Despite the risks, it's good to see the economic growth approach the rates that President Trump promised it would.

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