Last week’s employment report pushed the Federal Reserve (Fed) one- step closer towards large-scale bond purchases. The September jobs report was only slightly weaker than consensus forecasts, but far from strong enough to convince Fed policymakers that the economy would not benefit from another dose of medicine. While Fed bond purchases seem increasingly likely, many questions remain about how exactly the Fed would implement such a program. A new wrinkle emerged last week, as bond market participants discussed the possibility of interest rate targeting. The possibility of bond purchases will remain a positive force behind high-quality bond prices. We continue to believe that more economically sensitive bonds may benefit more from Fed purchases.
Short to intermediate Treasury prices continued their march higher and yields fell by 0.07% to 0.15% (according to Bloomberg), as the September jobs report pushed the Fed one-step closer to large-scale bond purchases. Treasury Inflation Protected Securities (TIPS) prices increased even more than conventional Treasuries as investors sought inflation protection on the premise that Fed purchases would generate future inflation. Yield premiums on Investment-Grade Corporate bonds and High-Yield bonds declined on the week as Fed purchases are viewed as a positive for more economically sensitive bonds.
The concept of interest rate targeting emerged as a new wrinkle the Fed may pursue in implementing large-scale bond purchases. Under interest rate targeting, the Fed would essentially seek to set a ceiling on the yield of a particular Treasury security. For example, the Fed may target a 2.0% ceiling on the 10-year Treasury or a 1.0% target on the 5-year Treasury note. While the levels may vary, the focus maturities will likely range from 2- to 10-year
Treasuries, as these securities are benchmarks for a host of consumer loans, like mortgages, car loans, and home equity lines of credit.
The potential benefits of interest rate targeting include:
Rather than merely conduct Treasury purchases with the objective of generically lowering market interest rates, stating a specific yield level makes the Fed’s objectives clearer. Depending on how far the current rate is away from the Fed’s target, investors will know how much force the Fed intends to exert in order to achieve the desired interest rate. Investors would then be discouraged from selling if the yield strayed too far above the target and, conversely, investors might buy in anticipation of Fed purchases. In this way, the Fed could utilize the bond market as an ally in seeking its objectives, and perhaps achieving the same policy goal without having to buy as much debt in the open market.
By announcing a yield target, the Fed may not have to announce a particular dollar amount. Setting a target enables the Fed to enter the market on an as-needed basis to achieve the desired rate. The European Central Bank (ECB) pursued similar logic in regards to purchases of troubled European government bonds. Purchases were substantial at first, and then tapered as fear receded and governments could fund effectively in the secondary market, and subsequently increased in September as concerns flared up among select issuers.
Fed Chairman Bernanke has already expressed his approval of interest rate targeting as an option. Bernanke, in a well-known speech in 2002, “Deflation: Make Sure It Doesn’t Happen Here”, stated that he “prefers” interest rate targeting as a method to lower Treasury yields and, in turn, lower key interest rates on public and private sector loans and other debts.
A large-scale bond purchase program would likely continue to help benefit more economically sensitive sectors such as investment-grade corporate bonds and high-yield bonds. In late 2008, the Fed lowered the Fed Funds rate to a range of 0.0% to 0.25% and followed up existing Mortgaged-Backed Securities (MBS) purchases with Treasury purchases. Throughout 2009, these actions forced investors into longer-term maturities in search of higher returns. This, in turn, created a domino effect, which forced government bond investors to buy higher-yielding corporate and high-yield bonds. We believe a large-scale bond purchase program would have the same impact this time as the insatiable search for yield forces investors in higher-yielding segments of the bond market. In addition, lower yields will extend the existing trend of investment-grade and high-yield issuers refinancing existing debt with lower interest cost debt thereby lowering their overall costs.
Three weeks remain until the Fed’s next policymaking meeting on November 2, but the bond market has already begun to do the Fed’s work. Since August 10, when the Fed first announced that proceeds from MBS would be reinvested into Treasury securities, Treasury prices have increased and yields have declined by 0.20% to 0.40%. Half of the yield decline came after the September 21 Fed policy making meeting when the Fed indicated inflation was below their goal.
While the potential implementation of how the Fed goes about bond purchases is unknown and could lead to volatile conditions, the prospect of large-scale Fed purchases both implied and actual will help support high- quality bond prices and keep yields low. We believe the 10-year Treasury yield will be range-bound between 2.0% and 2.5% until further clarity around the “how” of Fed purchases is clarified in coming weeks. Beyond the Fed meeting, we still expect high-quality yields to remain low with any rise in yields likely limited given the prospects of Fed purchases. Therefore, any rise in the 10-year yield is likely limited to 2.75% or 3.00%, in our view, as long as Fed purchases remain a possibility.
- IMPORTANT DISCLOSURES
- The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
- Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
- Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.