Fed's balance sheet and tightening: limited impact on yields - BBH

Analysts from BBH, take a look at what happened and what could occur with US bond yields if the Federal Reserve starts reducing its balance sheet. 

Key Quotes: 

“Another debate that appears to be intensifying among officials and investors is the relationship between reducing the Fed's balance sheet and tightening.  We have always been skeptical that a certain change of the balance sheet is tantamount to change in interest rates. Leaving aside economic theory for this unprecedented policy course and looking simply at what happened under QE, it appears that the anticipation and signaling effect was what spurred the decline in yields more than the actual buying. This seemed to be the conclusion of the ECB's experience as well.”

“It is true that the bonds that the Federal Reserve has been buying needs to be replaced by other economic participants. However, buying by financial institutions, households and the vast cash held by corporations, not to mention foreign investors, remains strong, which is why bond yields are lower now than when the Fed hiked last December or in March.  Also, as we have noted, the US Treasury has recommended changes in the calculation of the leverage ratios, which would reduce the funding costs of Treasury holdings by banks.”

“There are two main thoughts about why interest rates are low. The consensus view emphasizes central banks activity. In our work, we have tended to lay more weight on slow growth, low inflation, and the surplus capital. The consensus argument lends itself to expecting interest rates to rise as the central bank's withdraw from their extraordinary measures. However, stronger economic data and firmer price pressures encourage central banks to normalize policy.  We note the secular decline in US bond yields since 1981 and the low point was reached not during QE, but after QE had ended and a gradual monetary tightening cycle had begun (July 2016, 1.32% for the 10-year note).”