The Federal Reserve Bank (Fed) raised short-term interest rates by 25 basis points (bp) last Wednesday, March 15th. We are often asked, “when will the rate hike be reflected in…(the yields paid on various types of bonds)”? The bond market is typically ahead of the action, right or wrong. The Fed was very forthright with their intentions to hike short-term rates well ahead of the FOMC meeting. Investor sentiment began influencing rates on these early indications. As a matter of fact, the immediate post-action of the actual event was that interest rates moved lower. As Kevin Giddis, head of Raymond James fixed income, put it, “what we saw was a market that was prepared for the worst, and got the best.” The early anticipation that moved interest rates up was reassessed not because the projected event occurred, but because the tone of the accompanied Fed message was less hawkish than the market had accounted for. In other words, interest rates moved up “ahead” of the actual Fed hike and the market corrected the “over-reaction” based on future anticipation of the Fed being less aggressive going forward.
|Treasury Yields||12/30/16||03/20/17||Net Chg|
Source: Bloomberg LP, Raymond James
The Fed, to some degree, was able to manipulate interest rates during quantitative easing programs with open-market purchases of bonds in varying maturities. Now that the intent is to remove stimulus from the market, they may be able to primarily influence only the short-end of the yield curve. Recall that early anticipation was for the first of three 2017 rate hikes to be in May, not March. The market has paved the way and in many respects, pushed the Fed’s agenda ahead of schedule. Not surprisingly, the Fed has been influential in pushing Treasury Bill (short-term) rates up; however, the medium and long-end of the yield curve are up a mere 6-10bp on the year.
Going forward, the Fed is going to have to balance the speed at which it scales back stimulus with how healthy the economy really is. If it scales the stimulus too quickly, it could impede growth or even spiral us backwards. The market’s reaction was not as enthusiastic about the economy and thereby keeping longer term rates mostly static. Inflation has also not been a driving force. The net result is a flattening yield curve as short-term rates close the gap from medium and long-term rates. Should this eventually turn into a flat or specifically inverted curve, history suggests we should take notice. The Treasury curve inverted prior to the recessions experienced in 1981, 1991, 2000 and 2008.
March Madness is upon us and the predictability seems certain or so we claim it to be what seems like year-after-year-after-year. And year-after-year-after-year we seem to be wrong. It reminds me of the Bazooka Joe “proverb”, “even a broken clock is right twice a day”. And no, I’m not talking about Villanova or Kansas or North Carolina or Gonzaga. I’m talking about interest rates and the Fed.
The future implied probability of a March FOMC rate hike is 100%! I guess the broken clock will be aligned just perfectly this Wednesday at 1:00 c.s.t. It sure seems like a broken situation when you consider the overall slow growth and low inflation of our economy. But… we can make statistics look like anything we want. You know how that’s done. If you graph data over a 5 year period it looks a certain way but the perception may change completely if you graph the data over a 20 year period. Everybody’s viewpoint gets slanted and is just a little bit different and the perception on the bond market is no exception.
Since the beginning of the year, the 1- to 5-year part of the curve has moved fairly together:
The later part of the curve has lagged slightly behind:
The central banks around the globe have controlled interest rates as best they can for years now. The open-market purchases of bonds have ballooned the central bank balance sheets and influenced rates across the yield curve. The influence of raising short-term rates may be very different. The market has paved the way and in many respects, pushed the Fed’s agenda ahead of schedule. Recall that early anticipation was for the first of three 2017 hikes to be in May, not March. Watch the shape of the yield curve. The Fed will likely influence short-term rates and continues determined, despite mixed economic data, to raise them. The long-end of the curve is largely dictated by inflation and the market, neither apparently convincing influences for higher rates. What may very well develop over the course of the year is a flattening curve, often a precursor to a recession. How global interest rate disparity changes, domestic GDP grows (or does not grow), inflation deviates and economic data reveals may eventually over-power any Fed stubbornness to will their way.
Mark your calendars for next Wednesday the 15th (aka the Ides of March when the Fed will announce what is seemingly becoming a guaranteed rate hike. This would mark the fastest pace of a rate hike in the post-recession world, as the committee has only hiked once per year in each of December 2014 and 2015. Although members of our central bank have hinted that is less about the “pace” and more about the “path” of future rate hikes, the markets are seemingly convinced that we will shortly be on course for “faster and quicker”. Interestingly enough, since the last rate hike the markets have pushed up the front end of the yield curve (reflecting the increasing fed funds rate) yet simultaneously pushed down the back end. According to Bloomberg futures data, there is now an ~94% chance the Fed hikes rates by a quarter point (0.25%) in mid-March, yet the bond markets don’t seem to be bothered by the prospect of higher rates on the front-end of the curve.
As you can see from the chart above, the 1-5yr portion of the US Treasury curve has steepened (yellow, left) as prospects for a rate hike are all but certain, yet the same rationale for the hike: higher wages, job growth, economic expansion and rising inflation, don’t seem to matter much to the longer-term trend five to thirty years out (blue, right). In fact, since the Fed’s last hike in December rates <2yrs to maturity are higher yet every other maturity is lower in yield. Considering some of the discussions out of Washington are indicating that any pro-growth initiatives may take until late 2018 to show up in the data, it could make some sense that the yield curve is willing to go along with this thesis and push near-term yields higher, but remain wary of any long-term effect these could have. By the time we see any effects of these policies we’ll have to deal with mid-term elections as well as the beginnings of the next presidential campaigns.
Furthermore, the post-election “reflation” trade has faltered despite the more hawkish (pro-hike) rhetoric out of the Fed. Rates moving up should indicate a healthy economy that can support broadly higher levels of interest rates, yet markets see much of the pro-growth fiscal policies out of Washington proving only a temporary boost before moving back towards their longer-term trend levels. The chart below is the spread (difference) between 10yr and 2yr inflation breakeven points. As a reminder, the breakeven point is a measure of inflation expectations compared to a nominal Treasury security. If the 10yr breakeven rate is 2%, it would mean that investors in inflation-linked bonds would be better off than a similar maturity fixed-rate bond if inflation averaged >2% of the life of the instrument. By comparing the two measures here, both short and long-term, we can get a better understanding of the timeline for inflation expectations. Currently at negative 0.14%, markets are saying that inflation in the coming years is likely to be higher than the long-term trend, which will likely have a lot to do with the current presidential agenda.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.