Bond Market Perspectives | Week of December 16, 2013
- The Fed has successfully communicated the difference between tapering and the timing of rate hikes, but the rise in longer-term bond yields back to near recent highs suggests the bond market is still nervous about tapering.
- The divide between benign Fed rate hike expectations and tapering uncertainty highlights the need to focus on short and intermediate bonds.
Getting the Message
The Federal Reserve (Fed) will have one more attempt to craft its message to the bond market as the 2013 event calendar winds down this week with the Fed's final meeting of the year. With the thinly traded markets that typically accompany the holidays, we believe the Fed will wait until 2014 before announcing a reduction in bond purchases, but the Fed will nonetheless attempt to be careful with its message. The Fed has mismanaged its message for much of 2013, but the bond market may be finally "getting it."
Rate Hike and Tapering Are Two Separate Events
Seven months ago, Fed Chairman Ben Bernanke first uttered the word "taper" and sparked a sharp
bond market sell-off in the process. Investors were caught off-guard by the prospects of a Fed shift from an accommodative, bond-friendly policy to a more restrictive policy that would argue for cheaper bond valuations and higher yields. The Fed spent much of the summer months backtracking and clarifying its message that tapering is not tightening (or frightening). A reduction in bond purchases was not necessarily indicative of pending interest rate hikes and each was to be
understood as a separate event.
In October of this year, the Fed further tried to separate a rate hike from tapering. Fed staff released two papers suggesting that interest rates may remain lower for longer than anticipated. The papers asserted that lowering the unemployment rate threshold, a potential trigger for raising interest rates, and tolerating a higher level of inflation, another trigger for interest rate hikes, could achieve better economic results. Expected incoming Fed Chairwoman Janet Yellen, a well-known dove, was believed to be an advocate of such policy. Taken together, the above indicated that interest rates may stay lower for longer than the Fed's approximate guidance of a mid-2015 interest rate hike.
Fast forward to today and the bond market has indeed taken the Fed on its word that a rate hike and tapering are two separate events. Fed fund futures, one of the better gauges of market expectations of Fed rate hikes, actually reflected a delay in the timing of the Fed's first rate hike. The timing of the Fed's first rate hike moved from mid-2015, immediately following the September Fed meeting when the Fed surprised markets with a decision to postpone tapering, to late 2015 as of mid-November 2013 and has been little changed since.
Rise in Longer-Term Bond Yields Despite Fed Rate Hike Expectations
Longer-term bond yields, on the other hand, have increased back near their highs of the year despite more benign market Fed rate hike expectations [Figure 1]. Earlier in 2013, as Figure 1 illustrates, Fed rate hike expectations moved in lock-step with bond yields. This is normal behavior, as better economic growth or the Fed signaling a shift to more restrictive policy leads to expectations of Fed rate hikes. Although the impact of possible Fed rate hikes is typically greatest on short-term bond yields, higher yields ripple across the bond market. This past November, bond yields began to rise again while rate hike expectations actually declined and continued to fall before increasing modestly in December.
The Fed has successfully communicated the difference between tapering and the timing of rate hikes, but the rise in longer-term bond yields back near recent highs suggests the bond market is still nervous about tapering. This may not be the Fed's desired outcome as the Fed is cognizant of the impact interest rates have on the economy, but the bond market is merely taking the Fed at its word.
The Fed's own metrics of better economic data and an improving labor market appear to have been met, even though inflation remains lower than when tapering was first suggested in May 2013. Last week's 10- and 30-year Treasury auctions witnessed soft domestic demand for the first time in several months, which likely also reflected tapering fears.
Impact of Better Economic Data on the Bond Market
The bond market has gotten the message of better economic data, which is the primary factor behind increased tapering prospects. The recent rise in Treasury yields over the past few weeks is
commensurate with economic data surpassing expectations on balance [Figure 2].
The strength in recent economic data, along with last week's two-year budget agreement that
eliminates the prospect of a government shutdown, increased the odds that the Fed may announce a reduction in bond purchases at this week's meeting. Still, based upon several market polls, only one-third of market participants expect tapering to be announced, which suggests the market is not fully priced for a tapering announcement. We place a low probability on the Fed tapering this week, but should it occur, Treasury yields may break through this year's peak of 3.0% on the 10-year and 3.9% on the 30-year. If, as we anticipate, the Fed does not announce a tapering, we expect the 10-year Treasury to hold within its 2.5% to 3.0% yield range over the next few weeks before yields move higher in 2014 in response to stronger economic data.
The divide between benign Fed rate hike expectations and tapering uncertainty highlights the need to focus on short and intermediate bonds. Since Treasury yields bottomed in late October 2013, the 10-year Treasury yield has increased by 0.38% while the 5-year Treasury yield has risen by 0.25% through Monday, December 16, 2013. Longer-term yields have increased much more relative to short and intermediate yields due to tapering fears, while at the same time the Fed's message that it may remain on hold for longer has lent support to short and intermediate bonds.
We do not expect the Fed to announce or begin to reduce bond purchases this week, but the Fed will likely attempt to massage its message to restrain any adverse bond market reaction like that of last spring. The bond market has gotten the message loud and clear: tapering is coming at some point, especially with the economy on track for further improvement. Higher rates are likely to accompany it. This suggests a continued focus on short and intermediate bonds, as well as lower-rated, more credit-sensitive bonds to protect against rising interest rates.
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Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make
interest payments semi-annually, and the income that holders receive is only taxed at the federal
High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to
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should be part of a diversified portfolio for sophisticated investors.
Tapering refers to the Federal Reserve (Fed) slowing the pace of bond purchases in their
Quantitative Easing (QE) program. To execute QE, the Fed purchases a set amount of Treasury
and Mortgage-Backed bonds each month from banks. This inserts more money in the economy
(known as easing), which is intended to encourage economic growth. Lowering the amount of
purchases (tapering) would indicate less easing of monetary policy.Fed Funds Futures are a product offered by the Chicago Board of Trade which allow investors to speculate on what the Federal Reserve will do with interest rates.
The Citigroup Economic Surprise Indices are objective and quantitative measures of economic
news. They are defined as weighted historical standard deviations of data surprises (actual
releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests
that economic releases have on balance beating consensus. The indices are calculated daily in a
rolling three-month window. The weights of economic indicators are derived from relative
high-frequency spot FX impacts of 1 standard deviation data surprises.
Government bonds and Treasury bills are guaranteed by the US government as to the timely
payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed
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