Fed Said Higher Rates Ahead – How Will Bonds Respond?

Quite the first Federal Open Market Committee (FOMC) meeting for Fed Chair Yellen (her preferred title)! What was expected to be a do-no-harm, uneventful (and frankly boring) augural FOMC meeting to kick off her tenure quickly turned into a free-for-all at the front end (1-5 years) of the interest rate market. For example, 2-year Treasurys rose 7 basis points (bps) to 0.42%, the most since 2011, while 5-year and 10-year rates rocked higher as well. Interestingly enough, the volatility had nothing to do with the US$10 billion of additional tapering announced by the Fed, nor the removal of the 6.5% employment threshold (since both were expected). It was two items not involved with the actual FOMC statement. First, Fed officials released a forecast that the target fed funds rate could be 1% by the end of 2015 and 2.25% by the end of 2016. And second, Yellen’s press conference description of what’s meant by “a considerable time” between the ending of the quantitative easing (QE) and actually raising interest rates; in her view, that time period equates to “around six months.” This would mean that the first rate increase could occur as early as March or April of next year, much earlier than what the market was expecting.

All is not lost though, since the encouraging news is two-fold. First, a move forward of projected rate increases signals confidence from the Fed in the underlying growth in the domestic economy, including future labor gains. Second, even given the rate move, we witnessed some investors step in and buy risk assets amidst the volatility, including investment grade credit, because investors felt the higher rates (and flat-to-wider spreads) were a good opportunity to add risk at cheaper levels.

But don’t throw all caution to the wind. Be mindful of how this rise in rates will extend toward the intermediate and long ends of the yield curve, since increased growth expectations (and thus increased inflation expectations) would force those rates higher as well.  We believe opportunities will exist to add risk assets at these cheaper levels, but will be judicious in adding duration.

Overall, the Fed had one goal in this first meeting under Yellen…keep front-end interest rates anchored as they systematically remove QE accommodation – and they missed the mark.  Time to go find that anchor again…



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