The focus on the Federal Reserve on Wednesday was mainly around it starting to use 50 basis point hikes to tamp down inflation, but the central bank also shared plans to start trimming its pandemic-bloated balance sheet.
In its plan, the Fed will allow Treasury bonds and mortgage-backed securities on its $8.94 trillion balance sheet to mature at a rate of $30 billion and $17.5 billion per month, respectively, from June to September. Those roll-off amounts will accelerate to $60 billion per month for Treasury bonds and $35 billion per month for mortgage-backed securities through the fall.
Kevin Flanagan, WisdomTree's head of fixed income strategy, said the “uncharted territory” of aggressive rate hikes in the next several months and quantitative tightening will likely push yields higher across the Treasury curve.
He suggests exposure to floating-rate Treasury notes such as through as better rate hedges than short-duration and TIPS bonds. The iShares Treasury Floating Rate Bond ETF (TFLO) and the WisdomTree Floating Rate Treasury Fund (USFR) are two of the largest floating-rate ETFs today.
However, he expects turbulence over the next few months as the combination of hikes and balance sheet reductions take effect.
“There really aren’t many places to hide in the fixed income arena at this stage of the game,” he said.
While Fed Chair Jay Powell told reporters at a press conference that a 75 basis point hike to the target range isn’t being considered, market participants aren’t sure. The CME FedWatch tool is estimating an 83% chance the Fed will go for a three-quarters percentage hike in its June meeting based on futures pricing data.
Flanagan suggests investors keep an eye on broader financial conditions, as he expects the Fed to use those reports as a guideline for slowing hawkish policies ahead of reaching the neutral rate.