The Fed pushes – bonds push back

On March 15 the Federal Reserve raised short-term interest rates for only the third time in 10 years, to a range of .75 percent to 1.00 percent. With Fed funds futures pricing in a 100 percent probability of an increase prior to the meeting, the Fed had no other option if it wanted to avoid a major market surprise. The only uncertainty surrounding the meeting involved what Fed Chair Janet Yellen might say in her written statement and post meeting press conference. Investors wanted to know if further rate increases could be expected in 2017, and what Fed governors planned to do about winding down their $4 trillion balance sheet.

Both the Fed’s formal statement and Yellen’s comments highlighted the need for additional rate hikes. They were interpreted dovishly, however, as some economists had speculated that higher inflation in the second half of 2017 might force as many as four rate hikes before year end. Yellen tapered those expectations by reiterating her desire for a “gradual pace” of increases going forward. The consensus now: a total of three quarter-point hikes in 2017, four in 2018 and four in 2019.

This sequence of increases, if enacted, would put the Fed Funds rate at between 3.0 percent and 3.75 percent by the end of 2019. This would still be quite low by historical standards. Prior to the 2008 crisis, for example, the Fed Funds rate was at 6.5 percent, and the inflation rate (as measured by the Consumer Price Index) was about 5.0 percent. With the current CPI running near 2.7 percent at an annual rate, the Fed’s rationale for keeping interest rates lower for longer is that current low inflation numbers don’t justify big increases. Simply put, with inflation under better control, there is no need to raise rates back to pre-2008 levels.

The real world effects of monetary policy often run contrary to what investors expect, however. Many believe, for example, that if the Fed were to raise short-term interest rates by more than 2 percentage points over the next 2 years, long-term rates would rise in lockstep. But because the long term bond market often anticipates economic events rather than simply reacting to immediate changes in the cost of money, this could be a dangerous assumption. In other words, the Fed may be determined to drive up rates in the short run, but the bond market may react differently because it is driven by different forces, including inflation expectations, other central bank policies and geopolitical trends beyond the Fed’s control.

This scenario is exactly what is playing out now. The Fed has signaled that short term rates are headed higher, yet the yield on the 10-year Treasury continues to slip. Immediately after the election, the 10-year yield went as high as 2.60 percent. With economic growth expectations diminished due to limited progress on the American Health Care Act, and ongoing uncertainty around President Trump’s other reforms, yields have fallen off their post-election highs, drifting back to about 2.25 percent. If other major policy initiatives like tax cuts and repatriation of offshore funds are also delayed, long term interest rates will almost certainly go lower. We will be closely watching which way rates go in coming weeks. If we break above 2.60 percent on the ten year for a considerable time, it could be a signal that we’ve escaped the deflationary “malaise” of the last decade. Conversely, if we fall below 2.00 percent it could signal the opposite.

Meanwhile, we haven’t changed our investment policy concerning fixed income investments. We seek capital preservation and a reasonable yield—the proper goals of prudent bond investors. If rates rise in the future, we will be able to reinvest our maturing bonds at more advantageous yields. If not, we will at least lock in today’s levels.