Investors are understandably eager to know whether the US Federal Reserve will raise interest rates in September, or in December, or early in 2016 – or never.
But, bond fund managers say, the date the US central bank’s Federal Open Market Committee (FOMC) meets and decides to raise short-term rates for the first time since 2006 is less important than what comes after.
“The question that matters is not when the Fed raises rates, but when they stop, and how soon,” said Jeff Moore, co-head of global fixed income at Fidelity Management & Research in Boston.
Rising levels of volatility across fixed income are at least partly attributable to market nervousness about whether the Fed will initiate a durable cycle of interest-rate increases.
“In past cycles, the Fed always raised rates more than just one time,” noted Jeffrey Knight, global head of investment solutions at Columbia Threadneedle Investments in Boston.
According to FOMC minutes from March 27, Fed chairwoman Janet Yellen cited the Taylor Rule when she discussed the possibility of raising the federal funds rate (the overnight rate on banks’ deposits held at the Fed). The Taylor Rule, named after economist John Taylor, suggests short-duration bond yields should be at least as high as the level of inflation. Yellen has suggested the Fed would like to normalise rates by 2017.
Although headline inflation in the US is zero, core inflation (which excludes prices of volatile factors such as food and energy) touched 1.76% in June. The federal funds rate has been at zero since 2009.
To achieve traditional normalisation in US interest rates would therefore require the fed funds rate to reach towards 2%. Bond managers don’t see that as feasible, at least not for the foreseeable future – unless inflation picks up more quickly than expected.
Inflation sets the pace
Inflation is probably the wild card that could trip up the Fed’s gradual exit from quantitative easing. If wages in the US rise more quickly than the bond market expects, it could prompt the FOMC to respond by accelerating rate hikes. Such a scenario would create a lot of tumult in bond markets and probably spill into equities and currencies.
Bond managers’ predictions vary. Columbia’s Knight, for example, is sceptical the Fed will raise rates by more than 25 basis points this calendar year. Current bond prices are assuming a 50bp hike by December or March, managers say. A few managers say after that the pace of rate increases may turn out to be faster and longer.
“The surprise may be how high rates can go,” said James Evans, senior vice-president at Brown Brothers Harriman in New York.
While today bond managers are wary of rate hikes, which by definition will lower the price of outstanding bonds, they can also imagine a scenario in which the Fed would come under pressure to speed up its normalisation process.
By the end of this year, inflation in the US may look higher because the very low price of oil from last year will have moderated, while wages are increasing – such as an important increase announced last week for fast-food workers in the state of New York. “There will be calls for the Fed to be more aggressive” if that happens, said Henry Peabody, a fixed-income portfolio manager at Eaton Vance Management in Boston.
Other managers are more sanguine. Michael Materasso, co-chairman of the fixed income policy committee at Franklin Templeton Investments in New York, said rate hikes should be quite slow and modest because the US economy is in a prolonged period of expansion, which is good for credit.
The US business cycle has been in growth mode since 2009, and traditional cycles last about six years. But this one is longer because the depth of the financial crisis wiped out the sort of egregious behaviour (such as reckless borrowing, by companies or households) that turn a business cycle negative.
Referring to a nine-inning game of baseball, Materasso said, “If you believe the business cycle is in the seventh inning, you’re wrong: it’s in the fourth inning.” He said the US has another three or four years to go of growth. “Reversing QE will take a while,” he added.
Lisa Emsbo-Mattingly, director of research for global asset allocation at Fidelity, agrees. Indicators around corporate profits, credit availability and investment all suggest the economy will continue to expand for a while. Therefore, she said, interest rates are too low.
The Fed hesitates
Many managers said they believe the Fed has been slow to act because it fears triggering another "taper tantrum", such as the 2013 sell-off in emerging-market bonds and currencies that followed the Fed’s first discussion of paring back its QE programme.
To some, this hesitation isn’t helpful. “This feels like a classic Fed delay,” said Michael Swell, managing director at Goldman Sachs Asset Management in New York. “They’re waiting until they see the whites of the eyes of inflation.”
But focusing on the exact timing of a Fed hike misses the point. “The change in the rate regime is upon us,” said William Adams, CIO of fixed income at MFS Investment Management in Boston. “We know it, so we must position the portfolio accordingly.”
According to fund managers, that includes readying a plan to reduce risk if conditions become choppy, increasing cash levels to take advantage of spikes in volatility, and extending time horizons. Some managers favour floating-rate loans, which are uncorrelated to interest rates; others prefer the most equity-like aspects of the bond market, including convertible bonds. Others are looking for relative value within high-yield or investment-grade corporate bonds, looking for those sectors or levels of credit quality that are ready to outperform others.
“There’s usually a bull market somewhere for bonds,” said Moore at Fidelity.