The US Federal Reserve (the Fed) raised its overnight interest rate (Federal Funds Rate) by 0.25% to a range of 1.75%-2% earlier this year (June’18). This marked the 7thrate hike since December 2015. Two more 0.25% interest rate increases are expected later this year. The Fed is raising interest rates and shrinking its balance sheet in order to keep the economy from overheating.
This month, the Fed started shrinking its balance sheet by $40 billion per month vs. $30 billion per month in the spring. It has a goal to shrink its balance sheet by $50 billion per month starting this October. This action has the opposite effect of printing money.
Due to the massive size of the Fed’s $4.5 Trillion balance sheet (mostly comprised of bonds), it should be able to shrink its bond portfolio by simply not reinvesting proceeds from maturing bonds. While the Fed does not have to sell bonds, its absence from buying bonds and reinvesting bond proceeds will be felt. The Fed had been the largest buyer of US Treasury debt for several years. In order to find other buyers for the increasing issuance of US Treasury bonds, long-term interest rates should rise.
In marked contrast, the European Central Bank (ECB) and Bank of Japan (BOJ) are still printing money and maintaining negative overnight interest rates of -0.4% and -0.1%, respectively. The ECB currently expects to maintain this interest rate through next summer. This is being done to stimulate their economies and lower unemployment.
In recent years the ECB could not find enough government bonds to buy, so it started purchasing corporate bonds. The BOJ expanded its purchases to exchange traded funds (ETFs) and is now the largest shareholder of Japanese stocks.
The ECB recently lowered its monthly printing of money from 30 billion Euros to 15 billion (about $20 billion dollars). It plans to no longer print money starting in January 2019. However, proceeds from maturing bonds will be reinvested in the bond market. The BOJ continues to print about 1.7 trillion Yen per month (approximately $15 billion).
This month will mark the first time in over ten years that the combined money printing from the Fed, ECB and BOJ is negative. By January 2019, their combined balance sheets may contract at a rate of $35 billion per month. This should have the effect of raising interest rates around the globe.
Central bank bond purchases in recent years resulted in lower long-term interest rates and a scarcity of high quality bonds. Consequently, some bond investors were drawn to lower credit bonds. Less credit worthy countries and companies were able to take advantage of investors’ desire for higher interest rates by issuing new bonds of their own. These trends could reverse in coming years, leaving some borrowers in a bind when their bonds come due.