Central Banks Are Draining the Pool!

You could almost hear the sound of rushing water as central bankers drained liquidity from the deep pool of global financial assets last week. Both the Federal Reserve and our friends at the European Central Bank (ECB) took action, with the Fed in the lead.

The Fed was bailing the pool with both hands last week as Mr. Powell announced the Committee’s decision to raise the Fed Funds rate 25 bps to a target rate of 1.75%-2.00%. He also signaled, according to Fed watchers, that there likely will be two more rate increases this year and another three next year. Additionally, the Fed dropped previous crisis-era assurances it will keep rates below its longer-run norms. And just to make sure we got the No-Life-Guard-On-Duty notice, the Fed continued to shrink its balance sheet.

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The ECB is also taking action, but less aggressively than the Fed. Last week Mr. Draghi announced the ECB will wind up its €2.4 trillion bond-buying program by the end of this year. The ECB did not raise rates, but acknowledged the potential for an increase next year, stating it would keep interest rates unchanged at current record lows at least through the summer of 2019. In announcing a pullback in bond-buying, the ECB is betting the euro-area economy is robust enough to ride out both the recent slowdown and new political risks, which include U.S. trade tariffs and worries that Italy’s new populist government will spark another financial crisis.

So what does this mean for high quality fixed income investors? The benefits are the return of yield and the value of safety. As we have discussed previously, after a number of rate hikes  bond yields are now generally well above inflation rates, even for shorter-duration treasuries. And as liquidity is drained from the pool and risky assets become more volatile, high quality fixed income becomes a safe choice – sort of like using a floaty in the shallow end of the pool.

Sources: The Federal Reserve, ECB, Bloomberg, Financial Times, New York Times