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Fixed-Income Insights

At the U.S. Federal Reserve’s policy meeting on September 20, it maintained its forecast for one more tightening in 2017. 

The U.S. Federal Reserve (Fed), eager as always to carefully manage market expectations, delivered a surprise-free coda to its policy meeting on September 19–20. The Fed announced that October 1 would be the start date for gradually unwinding its $4.5 trillion balance sheet, and kept the benchmark fed funds rate unchanged, at 1.25%. The outcome of these two policy decisions was never in doubt by observers of the Fed.   

That’s not to say, however, that the Fed and investors are fully in sync. The projections for inflation, and its “dot plot” projections for interest rates from the Fed’s policy-setting arm, the U.S. Federal Open Market Committee (FOMC), while modified slightly lower on September 20, remain above market expectations.  FOMC projections for the fed funds rate for 2019 fell by 20 basis points (bps), and its long-term outlook dropped, from 3.00% to 2.75%. Short-term fed funds rate projections were unchanged. Yields on two-year and 10-year U.S. Treasury securities ticked up higher in post-meeting trading on September 20 in response to a clear majority of Fed policymakers who expect one additional rate hike this year and three more hikes in 2018. The Fed’s reiteration of its tightening path could help push rates higher before its December meeting.

Implications for Bond Yields
The slow start to the Fed’s balance-sheet normalization (the “unwinding” process) suggests little impact in yields over coming months. However, by this time next year, the increased reduction in purchases will reach $50 billion per month, or $600 billion per year. The absence of the Fed’s purchases seems likely to affect yields of five- to 10-year Treasuries and mortgage-backed securities, as these markets attract fewer buyers than shorter-maturity debt. For perspective, the quarterly auctions of seven-year and 10-year Treasuries have averaged $28 billion and $21 billion, respectively, or $102 billion and $84 billion annually. The Fed’s absence in the market could at some point give rise to a steeper yield curve.

As we noted earlier, rates could adjust higher in the next few months, based on the Fed’s intentions for a December hike, especially since investors rate the probability of such an occurrence at just above 50%, according to Bloomberg data. During Janet Yellen’s tenure as Fed chairwoman, she has presided over raised rates only when the implied probability of a rate hike was 70%, or more, according to Bloomberg. Over the past two weeks, the probability of a December Fed tightening has increased, to 54% from less than 30%, and two- and 10-year Treasury yields have increased, respectively, by 12 and 20 basis points. 

If the Fed tries to manage market expectations of a December rate hike higher over the next few months, bond yields could adjust higher. However, inflation figures also would have to rise, supporting the Fed’s intent. Higher inflation may indeed unfold owing the the effects of the recent U.S. hurricanes. Rising gasoline prices, followed by increased cost of building materials and other supplies due to weather-related shortages, could indeed boost announced inflation in time to support a December rate hike. Treasury yields likely will rise in the process.

Broader Investment Consequences
Depending upon the rise in Treasury yields, other markets could react accordingly. Higher rates, especially short-term rates, could provide support for the U.S. dollar, thereby stopping if not reversing the greenback’s 11% decline versus other major currencies so far this year. Bank stocks would be likely beneficiaries of higher 10-year yields and, in the longer term, any steepening of the yield curve. High-yield securities and bank loans also would perform relatively well, as economic strength keeps default risk low and economically sensitive securities perform better than those that are more responsive to changes in interest rates. The next several months could provide some interesting opportunities for investors as the market waits for the Fed’s final meeting of 2017.  

 

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