Economic Update—June 20, 2013
What Did the Federal Reserve Really Say and What Does it Mean for Interest Rates and Bonds?


By Steve Scranton, SVP, CFA
Chief Investment Officer

We have received multiple inquiries from clients wanting to know why interest rates have risen and bond prices have fallen over the last two months. Today’s commentary tries to provide some perspective on what has caused the rise in interest rates, implications for bonds and thoughts on strategies. As a result, this commentary runs longer than my typical single event economic commentary.

Decrease in Bond Prices

One of the mathematical realities is that bond prices move in the opposite direction of interest rates. So, when interest rates increase, bond prices fall. How much they fall depends on their maturity, coupon and structure, but the general rule is that the longer a bond’s maturity, the more the price will fall. Over the past two months, longer-term bond yields have risen almost 1% and prices have fallen. Since 30 year mortgage rates track the direction of 10 year Treasury rates, this has meant that 30 year mortgage rates have risen. As a result, 30 year mortgage rates are now above 4%. Unfortunately, for those individuals or institutions that own longer-term bonds or mortgage-backed bonds, they have seen noticeable price depreciation in their bonds.

Why Have Interest Rates Risen?

First, it is important to remember that the fixed income markets are supposed to be forward looking. So interest rates and price movements do not solely reflect what is happening today. Market participants will interpret data and then anticipate what that means for the future as well as for today. So, let us step back to look at various factors that could help us understand why rates have increased and bond prices have fallen.

  1. Reduced demand, assuming supply remains the same, will cause prices to fall.
    • When the Federal Reserve (Fed) stops purchasing securities, all else being equal, demand will be reduced. When that happens, logic would indicate that yields should return to where they were before the Fed began buying securities.
      • On 12/12/12, the Fed announced the beginning of their program to buy $40 billion of Treasury securities each month (i.e. increased demand) in order to inject more liquidity into the economy.
      • ii. On 12/12/12, the 10 year Treasury yielded 1.70%. Today, the 10 year Treasury yields 2.40%. The rise in rates is not due to the market re-pricing back to where yields were before the Fed began their QE3 campaign.
    • The budget deficit has decreased since December 2012, so supply is actually decreasing rather than remaining the same.
      • The reality is that even when the Fed begins to reduce their purchases of securities, the reduced supply of Treasuries may offset the reduced demand. We do not know that at this time because the Fed has not reduced its level of purchases.
  2. Fears of inflation may cause market participants to raise rates/lower prices to compensate for rising inflation.
    • Perhaps interest rates have increased/prices fallen because market participants fear that the massive amount of liquidity that the Fed has been pouring into the economy (via their bond purchases) will cause increased inflation.
      • The Consumer Price Index stood at 1.7% in December 2012 and today the Consumer Price Index stands at 1.4%.
      • If future expectations of inflation were rising, the price of Treasury Inflation-Protected Securities (TIPS) should be rising. In fact, prices are falling.
    • Logic would also argue that if the Fed buying securities will cause higher inflation, then reducing the amount of securities purchased should reduce the risk of rising inflation and make market participants happy.
  3. An improving economy causes market participants to demand higher interest rates.
    • Mood and sentiment, as evidenced by the various sentiment indices, has clearly improved throughout the U.S. Individuals, big business and small business sentiment indicators show individuals and companies becoming more positive about the economic outlook.
    • Actual economic data has remained fairly mixed, with manufacturing showing a clear slowdown while housing shows clear improvement. Consumer spending remains close to the levels that has existed since the recovery began.
    • The economy continues to grow between 1-2%. If interest rates are rising because of economic growth, then it would have to be based expectation/hope of better economic growth.
  4. Fear that the Fed will begin raising rates causes market participants to anticipate the increase and raise interest rates.
    • It appears that market participants have interpreted/misinterpreted the Fed’s comments and believe that rising interest rates are the new strategy from the Fed. As a result, interest rates have risen, and bond prices have fallen as the fixed income markets price in the anticipated Fed action.
What Did the Fed Actually Say?

This is what the Fed has actually said (not to be confused with what the market has interpreted/misinterpreted):

From the 6/19/13 Federal Open Market Committee (FOMC) statement (bold and underline added for emphasis):

"The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives."

Comments from Fed Chairman, Ben Bernanke on 6/19/13 stated (bold and underlines are added for emphasis):

"IF the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year...IF the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps throughout the first half of next year, ending purchases around mid-year.
What Did the Market Participants Hear From the Fed?

Given how quickly and how far rates have moved, it appears that the fixed income markets are pricing in the first actual interest rate increase from the Fed rather than just a reduction in bond purchases.

In reviewing the factors discussed above, it appears that the primary reason for the sudden increase in interest rates over the past two months is that market participants missed the “IF” and the “OR REDUCE” part of the Fed’s statements. The market seems to have heard: “We are going to stop buying bonds and we going to begin to raise interest rates”.

The reality is that, even though the Fed did not actually make those statements, both of those statements are true. What may not be true is the markets’ expectations for the timing of when the two statements will play out. Let us go back to what the Fed said and try to gain some perspective on timing.

First, as it relates to when the Fed will begin reducing its purchases and stop buying securities, if we revisit the 6/19/13 FOMC statement, the Committee once again provides insight (bold and italics added for emphasis):

“The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.”

So, if the economy improves the way the Fed is forecasting, then they will begin reducing their purchases of bonds.

  • As discussed previously, market participants seemed to have missed the “if” in Chairman Bernanke’s speech and the “or reduce” portion of the FOMC statement.

What about raising interest rates? The FOMC had this to say:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

The Fed is pretty clear on what it takes to raise rates, and those conditions do not currently exist. Based on the Fed’s own economic forecast and the above criteria, this indicates that a rate increase will not happen until 2015.

  • It is very important to understand that ending bond purchases does not immediately lead to the Fed beginning a strategy of raising interest rates.
  • The other important part of the Fed’s communications is that both the termination of bond purchases and the beginning of a strategy to raise interest rates is dependent on the economy.
  • Talking about what their game plan is different than executing a new strategy.
  • The Fed is trying to be more clear on what will cause them to change course. Unfortunately, this also creates the risk of market participants reading more into what they say than what they actually said.
What are the Implications for Bonds?
  1. Bonds with long maturities are most at risk since this is the maturity range of where the Fed has been buying bonds.
    • We have never been an advocate to reach for yield by buying longer-term securities and continue to maintain that belief.
    • There is an old saying in the investment market which is: “your first loss is your least loss”.
      • If you hold long term bonds and are fearful of losses, then you need to consider whether you are still comfortable with holding those bonds or whether you want to go ahead and sell the bonds (i.e. take the “first loss”) before the loss grows.
      • Ask yourself the question: are you going to be willing to absorb a bigger loss in the future, once rates begin a steady path of interest rate increases, or will you be stuck holding a bond with a low interest rates because the loss has become too big to stomach?
  2. 30 year mortgage-backed securities are also at risk since this is the type of mortgage-backed security that the Fed is purchasing.
    • We do not currently invest in 30 year mortgage-backed securities for our clients.
    • The same questions apply to the mortgage-backed securities as to longer-term bonds.
What are Strategies for Bonds in This Environment?

These are the strategies that we are using for our portfolios. If someone else is managing your money, you should consult with them to understand what strategies they are using.

  1. Individual securities for the core bond portion.
    • Individual securities may show temporary losses in value, but an individual bond has a stated maturity and principal is repaid at maturity.
  2. Laddered portfolio with a short maturity structure
    • Having a portion of the bond portfolio maturing each year allows the money to be reinvested at the higher interest rates as they occur.
  3. Floating rate bond fund
    • Although a mutual fund, the securities held in the fund have a very short duration and the coupon is tied to a short-term market rate (LIBOR, Prime and Treasury Bills) which adjust up or down as the short-term market rates go down or up.
  4. Global macro fund
    • This type of strategy is designed to hedge interest rate risk by having the ability to both own or sell short securities depending on the interest rate environment.
  5. High yield
    • High yield bonds provide diversification against the core bond portfolio. Historically, high yield bonds (below investment grade) have had a better total return profile than core (investment grade) bonds during rising interest rate environments.
    • Conversely, high yield bonds do not perform as well during economic downturns and recessions.
  6. Emerging market bonds
    • Emerging market bonds provide additional diversification. Performance of emerging market bonds is tied more to the local economy than the U.S. economy as well as the local currency versus the U.S. dollar.
    • Emerging market bonds have suffered declines recently because of the appreciation of the U.S. dollar, but we continue to believe that over the longer term, emerging market bonds provide excellent diversification.

We are not moving money from bonds to stocks. As we have discussed in the past, current stock prices are not necessarily connected to the economic realities that exist. Bonds and stocks each have a role in a portfolio. Moving money out of bonds and into stocks is only appropriate if your goals have changed or your risk tolerance has increased.

Conclusions:
  1. The 30 year decline in interest rates is probably over, but this does not mean that rates will begin a steady path of increases immediately.
    • The days of 1.70% 10 year Treasury securities is probably behind us.
    • The days of 4.00% 10 year Treasury securities is probably not upon us yet.
  2. During a transition stage from declining rates to rising rates, volatility increases as market participants try to read the “tea leaves” as to the timing of Fed actions.
  3. Unless the economy substantially breaks its pattern of speeding up and then slowing down, rising rates may have a self-dampening effect on economic growth and prevent a substantial increase in interest rates until the economic growth pattern can be broken.
  4. Chairman Bernanke has been abundantly clear that he believes that the Fed raised rates too quickly when the economy started to show improvement during the Great Depression and caused the economy to tip back into recession.
    • This would seem to indicate that during Bernanke’s term at the Fed, they will risk holding interest rates low for too long rather than raising interest rates to soon.
  5. Sooner or later, interest rates will begin a steady path of increases. Planning now for the eventual steady rise in rates is similar to the Aesop’s fable of the ant and the grasshopper. It is better to be prepared for the interest rate “winter” (the ant) than to be forced to react when the event actually occurs (the grasshopper). By the time the event actually occurs, the markets will have already adjusted.