Crossing the river by feeling the stones

Jun 12, 2017
By Jeffrey Rosenberg, Jonathan Pingle

A huge post-crisis expansion of the Fed’s balance sheet pushed interest rates lower and lower. A looming unwinding of this balance sheet should put this process in reverse. The Fed will try to avoid a market tantrum through clear signaling of its process, yet risks remain.

Fixed income highlights

  • The evolution of the U.S. economy toward the Fed’s goals – full employment and stable inflation – implies a greater urgency in normalizing policy. This policy will soon include not just interest rate increases, but also balance sheet “runoff.” Debate is set to heat up in coming weeks and months on how the Fed will proceed.
  • We expect the Fed to move cautiously in its unwinding process – akin to crossing a river by feeling the stones – but the market consequences are harder to predict. Any lack of clarity over the pace and final destination of the Fed’s balance sheet unwinding has the potential to unnerve markets.
  • Our base case is for modestly rising U.S. rates, with strong global appetite for income helping limit any yield spikes. We are underweight U.S. Treasuries and neutral on mortgages, which we see as offering little cushion against the risk of hiccups in the Fed’s normalization process. We prefer up-in-quality credit.


Central bank purchases in recent years decreased the amount of government bond issuance available for private investors in the U.S.; in Europe and Asia it all but eliminated it. Term premiums have collapsed in response, with a big compression in the average spread between 10-year and two-year yields across G3 nations. See the chart below. The impact of reversing these central bank policies is hard to gauge – this will be the first time the Fed has ever used asset reductions as a tightening (or normalizing) tool.

Who stole my term premium?
G3 net debt issuance ex central bank purchases, 2007-2017

Chart: Who stole my term premium?

Sources: BlackRock Investment Institute and Morgan Stanley, June 2017.
Notes: The bars show net government bond issuance for the U.S., eurozone and Japan, net of central bank purchases via quantitative easing programs. The weighted average spread is the average difference between 10-year and two-year yields in the three regions, weighted by nominal GDP. The figures for 2017 are estimates.

Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views ...
Head of Economics, BlackRock Fixed Income Americas