Will They or Won’t They?

Rising Interest Rates to be Expected

Rising expectations for an interest rate increase by the Federal Reserve (the Fed) have been one of the drivers of the recent rise in Treasury yields. Rate hike expectations peaked when Fed funds futures pricing indicated the bond market had fully priced in an interest rate hike by the early November Federal Open Market Committee (FOMC) meeting. Fed rate hike expectations decreased over the course of last week but remain elevated, with a Fed funds rate increase to  .50% expected by the January 2010 FOMC meeting. Next week’s FOMC meeting will provide additional clues, but we believe the Fed will remain on hold beyond current market expectations.

• High unemployment and low factory use rates indicate considerable slack still exists in the economy.
• An interest rate increase late this year or early next would end one of the shorter “on hold” periods for the Fed.
• The Fed would likely unwind non-traditional, quantitative easing measures before increasing the Federal Funds target rate.

Views of the Fed

Based on our view of the Fed, we would not jump to short-term bonds and remain focused on intermediate bonds to take advantage of a steep yield curve and sector allocation in corporate bonds. The Fed has historically been one of the primary drivers of bond market, as the Fed funds rate and short-term bond yields are highly correlated. Market expectations of what the Fed might do are best reflected in Fed fund future contracts. Currently, Fed fund futures reflect a Fed funds rate increase to 0.50% at the January 2010 FOMC meeting followed by steady 0.25% rate increases thereafter. We would prefer to err—if at all—on the side of the Fed remaining on hold longer than what is currently reflected in Fed fund futures pricing.

A high unemployment rate (9.4%) and record low factory use rate (65.7%) suggest ample slack in the economy. The Fed will likely encourage elimination of this slack by keeping interest rates low rather than increasing interest rates. Historically, the Fed has waited for several months of lower unemployment (see chart) before embarking on campaign of raising interest rates.

Should the Fed raise interest rates by January it would mark a relatively short “on hold” period, especially after factoring in non-conventional measures. Given the severity of the current economic downturn and unprecedented events of the past nine months, the Fed will likely err on the side of keeping rates low for a longer period of time.

After The Cut

Following the final rate cut, the Fed continued with non-conventional measures such as buying Treasuries and Mortgage-Backed Securities (also known as “quantitative easing”). The Fed increased quantitative easing at the March FOMC by expanding Agency and Mortgage-Backed Securities purchases and initiating Treasury purchases. One could argue that the Fed continued to ease through December 2008 (shown in Table at left) based on this dynamic, implying a later end to monetary easing than the January 2010 date priced into Fed fund futures at this time. We would likely see these programs unwound as a precursor to raising interest rates. Next week’s FOMC meeting may provide the first glimpse the Fed is ready to pause its bond purchase programs. The rise in Treasury yields has pushed residential mortgage rates up nearly a full percentage point over the past several weeks and raised the possibility of additional Treasury purchases.

However, comments from Fed officials since the last FOMC meeting suggest the Fed may not increase bond purchases. In June, Fed Presidents Janet Yellen and Jeffrey Lacker have spoken about inflation risks of buying too many Treasuries and keeping rates artificially low. Most recently, New York Fed President William Dudley, a voting member of the FOMC, also expressed concern over investors’ perception of Treasury purchases as inflationary. Such a perception, if it led to higher and higher interest rates, would be counterproductive for any incipient economic recovery. Furthermore, he stated that if forced to choose between a longer period of low mortgage rates or higher interest rates in response to an economic recovery, he would opt for a recovery. It appears Fed officials are comfortable with higher Treasury yields in response to an improving economy.

Still a Buy?

Still, a pause does not mean the Fed will unwind its stimulus and will likely remain in “buy” mode until at least September. Beyond bond purchase programs, the Fed still operates an alphabet soup of special funding vehicles such as the Commercial Paper Funding Facility (CPFF), Term Auction Facility (TAF), etc. Use of many of these programs has begun to slowly decrease as credit markets have improved, but we are likely months away from more significant reduction. The Fed may overlap the unwinding of lending/purchase facilities and raising interest rates, but we would expect the Fed to first curtail non-conventional measures more aggressively.

Based on our view that the Fed will be on hold longer than what is implied by Fed funds futures pricing, we would not advocate a jump to short-term bonds as protection from higher interest rates. Eventually the Fed will have to remove easy monetary policy, but that time is not near enough to warrant an investment shift now. We remain focused on sector allocation, emphasizing Corporate Bonds and taking advantage of a steep yield curve via intermediate bonds. While we expect bond yields to rise over the course of the year, we expect the pace to be much more gradual than investors have witnessed since the start of May. Similarly, we expect the pace of Corporate Bond improvement to slow going forward but still expect improvement to offset or limit the impact of higher interest rates.

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