Fed takes balanced approach to trimming USA bond holdings

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On Wednesday, the Fed is expected to keep its benchmark interest rate unchanged between 1% and 1.25% and announce the process for unwinding its massive balance sheet.

"In determining the timing and size of future adjustments to the target range for the federal funds rate, the committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation", the Fed said.

According to the Fed's economic projections which were released on Wednesday, Fed officials expected the USA economy to grow 2.4 percent this year, higher than their forecast of 2.2 percent in June.

"While the median 2017 dot is still set to tentatively pencil in a December rate hike, we expect to see more members calling for a pause for the remainder of the year", says Patel.

Weak inflation data in the United States has prompted investors to dial back their bets on future rate hikes, but the market may be underestimating the Federal Reserve, according to Nick Gartside, global chief investment officer of fixed income at JP Morgan Asset Management.

"Our balance sheet will decline gradually and predictably", Fed Chair Janet Yellen said in a press conference Wednesday after the policy decision. At this rate, the Fed's balance sheet would still be above $3 trillion by late 2019.

Below are four more developments - in addition to the change in the Fed's policy of reinvesting all maturing debt - that may lead Treasury yields to continue their resurgence over the next few months. The Fed has also indicated that it will hike its policy rate again in December. After that, the monthly reductions will remain steady.

Some traders and investors had thought the Fed might have struck a more dovish tone given the potential economic impact of recent severe hurricanes and still sluggish inflation.

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The scheme saw the Fed's balance sheet grow from around $800bn in mid-2008 to $2.1tn in June 2010.

The Fed's decision to exit from balance-sheet policies comes a decade after the global financial crisis began to tip the economy into a recession at the end of 2007. It is now projecting long-term below 2%.

The "neutral" rate is the appropriate rate for the level of inflation, which has moved structurally lower over time.

She also said if prices rose too quickly the bank would be able to lift rates quicker.

So far this month, the 2-year Treasury yield has climbed more than 10 basis points, the benchmark 10-year note yield has tacked on more than 12 basis points, while the yield on the 30-year bond has advanced about 6 basis points, thus far in September. The projection for unemployment will show that the central bank has achieved its 4.6 percent target for full employment: The jobless rate is at 4.4 percent, near a 16-year low.

"You will see a gradual tightening of financial conditions that will come from the Fed shrinking its balance sheet", said Lewis Alexander, chief US economist at Nomura Securities. Yellen's four-year term as chair will end on February 3.

In addition to the Fed's gradual unwinding of its $4.5 trillion balance sheet, at a pace that will double to $20 billion a month after three months, the European Central Bank is expected to begin tapering its bond buys in coming months.

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