Bond Market Calm Is Threatened by Fed’s $1.75 Trillion MBS Shift

An article in Bloomberg notes that the Federal Reserve's bond buying strategy, which has calmed the bond market and reduced volatility over the last few years, may shift as interest rates rise and the Fed starts to shrink its $1.75 trillion position in MBS. The article states that as the Fed shrinks its balance sheet, it will "leave more in the hands [o]f private investors and result in increased hedging activity, a practice that has historically exacerbated swings in the Treasury market." Analysts reported on March 9th that hedging activity was triggered when 10-year yields hit 2.55 percent and then 2.6 percent. That pushed yields to a three-month high of 2.628 percent March 14th, later slipping to 2.50 percent as of March 21st.

Minneapolis Fed President Neel Kashkari added new urgency to the discussion when he said last week that he would "prefer the central bank announce a plan that explains how and when it will begin to reduce its balance sheet before boosting rates again," according to Bloomberg. While the increased volatility in the bond market may make it harder for investors, it could be welcome on Wall Street, where such an increase will help trading desks at banks boost their profitability, with "more opportunities based on higher volatility", according to Brad Scott, head of RBC Capital Markets in New York, and "more participants that are likely to enter the market."

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