The impact on bonds is rather interesting.
The gray bars show periods when QE was implemented. Especially after QE 1, periods of QE tended to coincide with rising rates. When QE was ending (shown by the decline in the yearly growth rate of the balance sheet), rates tended to decline. Despite the FOMC bond buying, rates rose mostly on fears of inflation. Once QE ended, those fears eased and bond yields declined. The most recent rise is likely due to expectations of fiscal stimulus that will boost growth and potentially raise inflation.
If the Fed’s expanding balance sheet was a supportive psychological factor for bonds and stocks, will the contraction have the opposite impact? Simply put, we don’t know. If the economy and earnings are improving, the drop in the balance sheet probably won’t matter. Unfortunately, if the economy disappoints, cutting the balance sheet could have a bearish impact on these assets.
Next week we will examine the impact of the Fed’s balance sheet on monetary policy.
This article is courtesy of Confluence Investment Management, a participant in the ETF Strategist Channel.
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This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security.