In Thursday’s article, “Hey Bernanke, What Are You So Afraid Of?” I noted that the current consensus for a rate hike in 2015 presupposes a pickup in economic activity, a falling unemployment rate, and slightly higher inflation than we have today. To what exactly was I referring?
Along with Wednesday’s FOMC statement, the Fed also released the “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, June 2013.” Included among the projections were four variables: Change in real GDP, Unemployment rate, PCE inflation, and Core PCE inflation. The central tendency of where participants view each of the four variables in 2013, 2014, and 2015 is shown below. Central tendency excludes the three highest and three lowest projections for each variable in each year (19 total participants).
Notice the expectation of rising real GDP and inflation as well as the expectation of a falling unemployment rate. Whether or not you agree with the Fed’s projections, the people who get to decide when to loosen or tighten monetary policy will do so in part based on their expectations for the variables listed in the table above. And the financial markets will attempt to price in ahead of time the expected moves from the Fed. At this time, one FOMC participant finds it appropriate to raise the federal funds rate in 2013, three want to do so in 2014, fourteen think starting in 2015 is appropriate, and one participant favors waiting until 2016 for the next rate hike.
More specifically, take a look at exactly what rate FOMC participants currently think the federal funds rate should go to in 2015.
Before commenting on what I think of the 2015 federal fund levels FOMC participants deem appropriate, let me remind readers of the following quote from the June 19 FOMC statement. “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.” If, as was mentioned at Bernanke’s press conference on Wednesday, the current round of QE ceases sometime in mid-2014, I find it highly unlikely that the Fed, given the statement above, would begin raising rates soon enough that any measured increase in rates (0.25% at a time) would get us to the 2% to 3% range four of the participants advocate.
Furthermore, given the Fed’s determination to keep the target range for the federal funds rate at 0% to 0.25% “at least as long as . . . 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,” I think even the participants who see the federal funds rate at 1% or higher in 2015 are quite optimistic. You may not believe in the accuracy of PCE inflation figures, but the Fed uses them as a gauge of inflation. Look at the 2015 projections noted earlier in the article. Participants think PCE will barely bump up against the 2% longer-run goal. If the Fed means what it says about keeping the federal funds rate at rock-bottom levels at least as long as “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,” then the risk of a rate hike in 2015, based on the Fed’s current PCE projections, is quite low.
There are certainly those who will say that the Fed’s projections are a bunch of nonsense and that when inflation breaks out over the next year or two, the Fed will be forced to raise rates. I will simply note that the source of inflation pressures is important to recognize when gauging how the Fed will react. Regarding commodity-futures induced inflation: In today’s short-term-trading mentality world, I don’t think it would be all that hard for the Fed, or other spheres of influence, to get the exchanges to raise margin requirements by whatever amount is necessary to bring prices back down (should lower commodity prices be desired). Regarding wage growth causing runaway inflation, we would need to see a massive strengthening in the labor market before that becomes a concern. And we are nowhere close to that at this time.
What does all this mean for bond investors? If and when a rate-hike cycle begins, I think the long end of the Treasury curve will react much faster than the short end, reaching its ultimate end point quite quickly before the curve begins to flatten noticeably. Given the longer-run consensus among FOMC participants for a federal funds rate of 4% and the secular demand for income that will be with us for many years to come, it will be difficult for the longer-end of the Treasury curve to break out above its 2009 high yield of 5.066%, let alone the highest yields from the previous cycle (around 5.60%).
Yes, if yields jump a couple hundred basis points from today’s levels, you will hear all about the massive mark-to-market price declines your bonds will suffer. And if you expect a rate-hike cycle in the coming years, taking the entire Treasury curve to at least 4%, if not higher, then most bond funds should be avoided. But remember that individual bonds are a different animal. You may decide that not purchasing one or more of the many longer-term triple-B-rated bonds currently yielding 6% to 7% is worth it if it means you can pick up those same bonds at 7% to 8% in the future. Or perhaps you want to avoid purchasing the single-A-rated longer-term bonds currently yielding 5% to 6% because you hope to buy them with yields of 6% to 7% in the future. But if benchmark rates rise due to an improving economy that also brings with it spread contraction back to historic lows, you may discover the wait for higher yields was not all it was cracked up to be.
At this time, we do have rising benchmark yields and widening corporate bond spreads, something I doubt will last for much longer. For benchmark Treasuries to remain, for an extended period of time, at current yields or higher, the Fed will eventually have stopped QE, and market participants will be well into pricing in a cycle of rate hikes. But the Fed won’t tighten monetary policy if there is a risk of a major stock market selloff. And there will be a risk of a major market selloff if the Fed stops QE and is believed to be considering raising short-term rates. Therefore, the Fed may temporarily stop QE, but once the stock market falls and starts a chain reaction that weakens the overall economy, the Fed will be forced to start QE once again. And it is that new round of QE as well as a weakening economy and falling stock prices from stopping the previous round of QE that would eventually bring with it declining Treasury yields.
Investors who are helping to push yields higher are simply giving bond buyers a major opportunity to get long various individual bonds. This is especially the case for the true long-term bond investors willing to purchase single-A- and triple-B-rated bonds currently yielding 5% to 7% and patiently hold them while collecting coupons and ignoring price fluctuations that are largely irrelevant. As I mentioned in a previous article, “If you are a true ‘long-term investor’ with a multi-decade time horizon, don’t shy away from individual bonds that meet your yield and credit criteria simply because they have many years to maturity. Remember that absent a default, those 25 to 30 year bonds will one day turn into five year bonds, one year bonds, and eventually a bond that has matured at par.”
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