What The Markets Are Telling Us About Interest Rates

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.

 The Bear Flattening Trade

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?

 

Investors may question the wisdom of buying long bonds if the Fed is going to raise rates.  Here are some of the reasons this makes sense:

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.

 

 

 

 

 

 

 

 

 

 

 

Is Monetary Policy Too Easy?

Is Monetary Policy Too Easy?

The Fed has been battling deflation since the financial crisis began in 2008.  Negative demographic trends and an over leveraged economy have led to sluggish growth in spite of unprecedented easing by the Fed.  The Fed Funds rate has been near zero for several years and the Fed’s balance sheet has ballooned as the Fed introduced us to Quantitative Easing (QE).  After the first round of QE the Fed moved on to QE2, QE3, and QE “infinity.”  The latest round of QE appears to be drawing to an end as the Fed continues to taper its purchases of UST and Mortgage bonds.  Research has shown QE has diminishing returns and encourages the movement of funds into riskier assets.  It also slows down or drags out the deleveraging process.  We have seen improvement in a very weak labor market, but the economy has been very sluggish.

Inflationary Pressures May Be Building

Inflationary expectations have been well anchored which has allowed the Fed to continue its monetary easing without upsetting the Fixed Income markets.  The bond vigilantes have been silent and are not expressing concern.  However, we are seeing early warning signs that inflation is starting to pick up.  The chart below shows the Core rate of the CPI since January 2008.  The blue line is the year over year rate of inflation and is less sensitive to monthly changes in the index.  It is increasing at a rate of 1.9% annually which is roughly in line with the Fed’s target.  The red line is the annualized rate of the last 3 months of the CPI.  It is more sensitive to recent monthly changes in the index.  This shows a different story, as it is growing at an annualized rate of 2.8%.

 

 

This is the highest this measure has been since early 2008.  We view this as a red flag that inflation may be picking up.  We will be watching this measure closely for further signs that inflationary pressures are building.

 

The Taylor Rule

 

The chart below shows the projected Fed Funds rate using the Taylor Rule Model.  This model uses the Core PCE deflator for the measure of inflation.  The model currently says the Funds rate should be 1.84%.

 

The Model below uses the Core CPI to measure inflation.  Using this measure the model says the Funds rate should be 2.7%.

 

Conclusion

The Taylor Rule model shows the Fed Funds rate is too low for the strength of the economy.  The recent strength in the annualized inflation rate using the last 3 months of Core CPI shows inflation may be picking up.  This is making us more cautious to the rates markets and we will be watching closely for further signs of an inflationary buildup.

 

 

 

 

 

Federal Reserve Forward Guidance

The Fed & Traditional Policy

The Federal Reserve’s traditional monetary policy tool is the federal funds rate.   The Fed encourages economic growth by lowering the federal funds rate and attempts to slow growth by raising the rate.  Since the financial crisis in late 2008, the Funds rate has been between 0.0%-0.25%; this is known as being stuck at the “zero bound.”  Since then, the economy has been in a liquidity trap, the system continues to be overleveraged, and there is a greater desire on the part of borrowers to deleverage rather than increase borrowings.   

The Fed & Extraordinary Policy Measures

The Taylor Rule, a widely followed “rule” regarding interest rate manipulation, called for a negative Funds rate of -2.0% from 2009-2011.  Since it is not possible to create a negative funds rate, the Fed has had to utilize other, less traditional stimulus tools in this environment. 

 

One of these tools, Quantitative Easing (QE), expands the feds balance sheet through asset purchases in the open market. By doing this, the Fed attempts to lower long term interest rates.  The fed has begun to taper these purchases, however, as the continued efficacy of QE has come into question and some argue that the economy is improving.  Another tool used by the fed is called Forward Guidance.  Through Forward Guidance, the Federal Open Market Committee (FOMC) attempts to communicate where they think monetary policy will be in the future.  This is similar to “jawboning,” where the Fed talks down long term rates by giving guidance about potential rate action in the future.

 

A Brief History of Forward Guidance

Below is a brief history of the feds Forward Guidance taken from the Fed’s statements after FOMC meetings. This appeared in the March 14, 2014 MarketWatch from the Wall St Journal:

1.       12/16/2008:  First Mention “Weak economic conditions warrant exceptionally low levels of the fed funds rate for some time.”

2.       8/9/2011: Added Specific Date “are likely to warrant exceptionally low levels for the fed funds rate at least through mid-2013.”

3.       1/25/2012: Extends Date “are likely to warrant exceptionally low levels for the fed funds rate at least through late 2014.”

4.       9/13/2012: Extends Date Further “are likely to be warranted at least through mid-2015.”

5.       12/12/2012: Adds Unemployment Goal “will be appropriate at least as long as the unemployment rate remains above 6.50% and inflation is not more than 2.50%.”

6.       12/18/2013: Continues After End of QE “for a considerable time after the asset purchase program ends.”

7.       3/19/2014: Drops Unemployment Goal  “likely will be appropriate to maintain the current target range for the fed funds rate for a considerable time after the asset purchase program ends.”

The primary lesson to be taken from this history is that the Fed reacts to incoming data concerning the economy, and forward guidance is not set in stone.  They have sought to provide guidance to keep long term rates low, but they have revised their comments and forecasts several times since the financial crisis.  They have consistently overestimated the strength in the economy and the need for monetary stimulus.

 

Connecting The Dots

The chart below shows the federal funds rate forecasts by the 16 members of the FOMC from the March 19, 2014 meeting.  There is consensus to keep rates low through the rest of 2014, but the vast majority sees rates higher by the end of 2015.  Yellen recently commented that rates would stay low through the middle of next year. 

However, when asked about the “dots” moving higher, she said we should not pay too much attention to the dots (even though the Fed is publishing them to give us guidance.) Her dovish comments have created uncertainty in the markets and bring into question the usefulness of Forward Guidance.

 

Forward Guidance Has Limited Value

We are in agreement with Yellen about the value of watching the dots.  The Fed has been providing guidance for the last 5 years.  They have consistently over-estimated the growth rate in the economy and have over-estimated inflation as well.  The dots have alluded to rate increases for the last 2 years, but this has not been the case.  We believe it would be better to focus on the growth rate of the economy and inflation expectations.  The chart below shows projected economic growth by the same 16 members of the FOMC.  They have overestimated growth for this year and show it peaking at the end of next year.  They are forecasting growth in the longer run of 1.8% to 2.4%.  These forecasts of sub-par long term growth and significantly higher short term rates are inconsistent with each other.  During the last few years the Fed has expanded its balance sheet and fought diligently in an attempt to get growth up to trend.  It seems unlikely they will raise rates if growth is even slower in the future.

Taylor Rule Revisited

Considering subdued inflation expectations, relatively high unemployment, and uncertainty regarding the future growth prospects of the economy, many question why the fed would consider raising rates. Perhaps the best explanation for the committee’s higher rate guidance is that the Taylor Rule currently says the Fed Funds rate should be about 1.0%, as shown in the chart below.

 

Conclusion

Future Fed actions are data dependent.  The rate of economic growth and inflation expectations will determine the level of interest rates.  Similar policies in Japan have led to sub-par growth and low interest rates for the last 20 years.  Past and current Fed action has likely drawn out the process of deleveraging in our country and will lead to below trend growth and relatively low rates for a long time.  Fixed Income investors would be wise to monitor the economic data, and pay less attention to forward guidance.