After the Federal Reserve announced September 20th it would begin shrinking its $4.5 trillion balance sheet by not reinvesting $10 billion of assets per month starting in October (capping it at $50 billion), many felt the bond market was in for a shake up. The combination of fewer asset purchases and verbal confirmation that the Fed is relatively happy about the economy caused many investors to bank on higher rates, pushing bond prices lower.

Years of accommodative monetary policy from the Fed that suppressed interest rates has made for a fruitful period for bond investors. But the improving economy and the Fed shifting from accommodation to tightening has seen interest rates slowly tick higher. Interestingly, since the Fed announcement, interest rates have halted, defying many expecting a bond market sell-off. The question investors are asking is why? (See also: How Will the Fed Reduce its Balance Sheet?)

Already Priced In

A likely explanation is that the Fed announcement was full priced in, meaning investors were ready for the move and had already positioned their portfolios for the decision. The Fed has been thorough in its communication about the balance sheet conundrum. It began in March when the Fed said that a "change to the committee’s reinvestment policy would likely be appropriate later this year."

By communicating well ahead of time, the Fed allowed investors to slowly re-balance their portfolios. Announcing such a momentous decision without warning would cause chaos in the bond market, much like the infamous 2013 taper tantrum when then Fed Chair Ben Bernanke surprised markets when he said the Fed, "anticipates that it would be appropriate to moderate the monthly pace of purchases later this year."

Source: FactSet

Investors Are Skeptical

The Fed is not always right. In 2013 the taper tantrum proved they were incorrect – by about four years. Perhaps they are wrong again? While the Fed announced its plan to scale back re-investments, it is not a definitive schedule. Should the economy slow, or inflation wane, like many believe it will in the short term, the Fed could reduce or even stop the tapering. 

In fact, some investors have begun opining the Fed will not deliver on it's promises. In its recent fund managers survey, Bank of America found that just 5 percent of investors are positioned for higher rates. "Cash levels remain elevated, suggesting markets can remain in an Icarus upside mode for risk assets," said Michael Hartnett, chief investment strategist at Bank of America. 

"Investors have shunned mean reversion and cut their expectations for much higher bond yields."

Global Uncertainty

As equities struggle in the wake of global tension over North Korean, investors continue to shift into less risky, safe-haven assets. (Along with gold, U.S. Treasuries are considered a safe haven asset.) As government-backed securities, Treasuries guarantee the interest rate stream and principle return. The underlying risks are price movements, not the actual asset, making them the ultimate safe haven asset – assuming the U.S. does not default on its debt.

The Take Away

While fundamental economics should see bond prices fall during a time of central bank tightening many variables shift bond prices. And as the balance sheet reduction begins, investors should not assume lower bond prices are a certainty.