Bond Traders Ignore Fed Balance Sheet Talk at Their Peril

(Bloomberg Gadfly) -- The Federal Reserve is trying to send a message to bond traders: prepare for a reduction in its $4.5 trillion balance sheet. But the traders aren't buying it yet.

Such a move would most likely cause longer-term borrowing costs to rise because the Fed has been a large buyer of Treasuries and mortgage debt since the 2008 financial crisis. More than $400 billion of its holdings is set to mature next year, so a reduction in the Fed's reinvestment could potentially depress market values.

Most Fed officials said they backed a policy change that would begin shrinking the central bank's balance sheet later this year, according to March meeting minutes released Wednesday. But debt investors aren't anticipating that the Fed will take action soon. Even as a string of Fed members espouse the merits of shrinking the balance sheet, bond traders haven't priced in any material shift in central bank strategy. 

Benchmark bond yields haven't materially increased, even among longer-dated notes. And perhaps more tellingly, the gap between longer and shorter-maturity Treasuries has remained historically narrow.

Jim Bianco, founder and head of Bianco Research in Chicago, said many traders think the Fed won't make a move until 2020 or beyond.

"It is a mistake to conclude that the current talk means the market is fine with the balance sheet being reduced," he said.

This is especially surprising because, last month, New York Fed President William Dudley said, “If we start to normalize the balance sheet, that's a substitute for short-term rate hikes.”

To be clear, traders have been disregarding Fed projections and promises for years, and they have been right. Bond traders have consistently priced in more subdued inflation and growth forecasts than central bankers, which led to fewer rate increases than promised. This may end up serving as yet another example of how debt investors are more aware of the underlying economic reality than Fed officials. 

But the fact that Fed members are becoming more vocal about their balance sheet plans is important, especially as the mix of central bankers is poised to change.

While Fed Chair Janet Yellen has a track record of adequately preparing markets for any policy shifts, her term expires next year. A new Fed leader may not be so successful at gently easing Wall Street into tighter lending conditions. Right now, bond traders are complacent about how easy it'll be to allow the Fed to unwind its historically bloated books. It's easy to see how they could be in for an unpleasant surprise. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

To contact the author of this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.