What
The Markets Are Telling Us About Interest Rates
It is no secret that the Fed is about to end purchases of
U.S. treasury and mortgage securities later this year. There is also talk of increasing the Fed
Funds rate sometime next year. What does
this mean for fixed income investors, and how should their portfolios be
structured for a rise in rates? There are
some things we can learn from the bond market to help us with this decision.
Markets often anticipate future changes. One indicator we follow for confirmation of
our Fed thoughts is the spread between 5 year and 10 year treasuries. The graph below shows changes in the Fed
Funds rate compared to the spread between 5 year treasuries and 10 year
treasuries for the period from January 2000 to the present. The blue represents the Funds rate and the
orange represents the yield spread between 5 and 10 year maturities. Changes in this spread tend to precede changes
in the Fed Funds rate. When the bond
market feels short term rates are going higher investors sell 5 yr bonds and
buy 10 year bonds in anticipation of Fed rate hikes. The lower the spread the flatter the yield
curve is. The spread is now at the
lowest it has been since the Fed took the Funds rate down to zero. This indicates a rate increase is likely.
Why Buy Longer
Bonds If Rates Are Going Higher?
1.
Short term rates have more potential bp’s to
rise and will rise more quickly than long term rates. These portfolios are duration weighted to
temper the risk of long term bonds declining in value.
2.
Investors are still being paid to extend
maturities and the higher rates on longer bonds help mitigate declines in
value.
3.
Inflation is barely at the bottom of the Fed’s
target range. Any increase in short term
rates will likely lead to inflation expectations being well contained.
4.
Increases in short term rates will provide a
headwind for the economy. This will lead to subpar economic growth.
A Look at the
Fed Funds Futures Market
The chart below shows what the futures market expects the
Fed Funds rate to be for the next few years.
The expectation is that the Fed Funds rate will be about the same for
the next 6 months and will then start to rise to 0.73% at the end of 2015.
According to the futures market it will continue to rise to 1.79% by the
end of 2016. Both of these indicators
show the market is telling us an increase in the Fed Funds rate is coming.
Fed Funds and
the Yield Curve
When the Fed talks about raising rates they are talking
about the Fed Funds rate. However, when
investors think about rising rates they worry about a decline in value of their
longer bonds. Our research shows a
strong correlation between the Effective Fed Funds Rate and the 10 year
treasury yield. The table below shows that
the average spread between the Fed Funds rate and the 10 year for the period
from 1/1/1962 to the present was 100 bp’s, and the maximum spread was 390
bp’s. In fact, about a year ago we felt
3.0% yields on the 10 year were very attractive since the 10 year was yielding
more than 300 bp’s over the Funds rate.
Municipal vs.
Treasury Ratios
We have also
studied the relationship between Munis and treasuries. The table below shows the long term expected
ratio for a 10 year Muni vs a 10 year treasury is about 80%. These ratios vary widely depending upon
market conditions. However, we can use
the expected ratios below to give us some idea of what to expect if the Fed
normalizes rates beginning next year.
Higher
Rates For Fed Funds
Using the historical
relationship between the Expected Fed Funds rate and various points on the
yield curve we can then do a shock analysis to determine what to expect if the
Fed raises rates. The table below shows modeled yield curves for both Munis and
UST assuming an increase in the Funds
rate to 1% and 2%. It may surprise some
investors to see that for a 1% Funds rate we should expect the 5 year to be
about the same as it is now, and the 10 year actually looks cheap compared to
an expected yield of roughly 2.0%. We
would argue that the market currently discounts a 1.0% Funds rate. If the Funds rate goes to 2.0% we should
expect a rise in the 5 year of about 100 bp’s and the 10 year about 60
bp’s. Munis show similar results, except
the 10 year Muni is fairly valued at a 2.0% Funds rate.
Conclusion
Fears of rising rates are
greatly overblown. The market has
already discounted a 1% Funds rate. Any
rise in the Funds rate will likely be several months from now and will be
limited in amount. Under current
circumstances it seems likely the Funds rate won’t be over 1% until the end of
2015, and might not reach 2% before the end of 2016. These increases are data dependent and won’t
occur unless the economy grows faster than we have seen so far. In the past we have cautioned about placing
too much faith in the rate predictions
of the Fed. Fed members have been
predicting higher growth rates for the economy for some time and have a history
of being overly optimistic about their growth expectations.
Since the economy still
has too much debt and the demographic trends are still negative, we feel the
risk to economic forecasts is to the downside.
We believe rates are likely to be low for a long period of time and rate
increases in the Fed Funds rate will tend to be an additonal headwind for
economic growth. If we are correct, then
the yield curve will continue to flatten.
An appropriate strategy for bond investors is a barbell strategy
consisting of some bonds with very short maturities and some longer bonds. We also are placing an emphasis on credit
spreads as a way to increase returns.
These strategies have worked well for us year to date.
