Sept. 17 is D-Day, or we should say T (for tightening) Day, for the Federal Reserve. While many pundits are convinced the Fed will tighten its Fed funds rate for the first time in nine years at the conclusion of the September Federal Open Markets Committee (FOMC) meeting, not everyone is convinced. It would be wise to think back to two years ago when a similar consensus was forming around a September FOMC meeting on the notion that the Fed would begin the process of tapering from open ended quantitative easing (QE3), which was pushed off until December 2013.
Perhaps more important than if they will tighten rates is how the market will react, and what road map for future rate hikes Fed Chair Janet Yellen will lay out in her remarks. If there is not quite a consensus on what the Fed will do, there is even less on how fixed income markets will react to it.
“Unless the U.S. economy shows rapid-fire signs of slowing down, it is a done deal the Fed will want to tighten policy at the September meeting,” says Andrew Wilkinson, chief market analyst for Interactive Brokers. “The reaction will be very well telegraphed. There will be a heightened chorus of people anticipating the tightening.”
The Fed’s long preparation, Wilkinson says, will prevent the type of market disruptions that occurred when former Fed Chair Ben Bernanke first discussed tapering QE3 in the spring of 2013 (see “Panic attack,” below). “It won’t necessarily set off a chain reaction of further tightening or market disruptions. It could be ‘one and done’ for the next three months, but I would not be surprised to see two [rate increases] this year — probably September and December,” Wilkinson says.
Kathy Jones, fixed income strategist for Charles Schwab, says, “Unless we have a very weak [July unemployment] report they are going to move forward in September.”
Jones adds, “They will raise rates very slowly, very gradually. There are some reasons for them not to get aggressive at this stage of the game: Where the economy doesn’t have a whole lot of momentum, where the global economy is soft and has some fairly fragile economies; [not to mention that] the dollar is strong.
Tory Enerson, senior market strategist with the Zaner Group, expects the Fed to raise rates in September and December.
Others are not so certain on the policy or its consequences. Martin McGuire, managing director at TJM Institutional Services, says that a rate move (prior to the July employment number) is data-dependent. While the July jobs numbers were solid and did not meet McGuire’s standard for pushing a move off, they wasn’t fantastic; nonfarm payrolls grew by 215,000. Two days later China devalued its currency, negating any momentum from the July jobs numbers.
Will they or won't they?
Others are more skeptical. “[Fed Chair Janet] Yellen is not going to do anything,” says Zaner Group Broker Judy Crawford, who says Yellen has allowed herself some wiggle room. “We are in a massive deflationary environment,” Crawford says. “It is an issue of whether the economy allows it, that is what [Yellen] is saying.”
ADM Senior Financial Economist Alan Bush also says there is a chance the Fed will hold off, not only in September but for the year. “There is a greater possibility now with China devaluing its currency, that the [Fed will hold off],” he says. “Because real wages [are stagnant], there is a low velocity of money and the dollar strength has become a problem.“
At some point they are going to raise rates, according to Anthony Lazzara of Lido Isle Advisors. “I don’t know when that is going to be; I am not sure anyone knows. We know it is going to happen but so much has been bled into the market that I don’t think it is going to have much effect on the market,“ Lazzara says.
He raises the larger question of market reaction. The Treasury market was spooked by the mere hint of tapering two years ago, but has had a lot more time to digest a rate increase.
“The Fed has done a good job explaining how and when they will tighten and what the implications will be,” Wilkinson says. “We will see barely any movement in either short-term or long-term rates. The market is quite well positioned and the fact that the Fed is underway with a tightening cycle will not be taken — as with prior cycles — as a sign for a bear market for bonds. The Fed has done a great job of getting the front end [and the back end] of the market to understand.”
McGuire agrees. “Whenever the Fed does decide to go, the market is going to be fine,” he says. “There is going to be no massive sell-off in [30-year] bonds. Ten-year [notes] may react a little, there will probably be a flattening between 10s and bonds, there will be a continuing flattening between [two-year notes] and 30s and [five-year notes] and 30s, but there will be no taper tantrum and there will be no massive unwind.”
Enerson, on the other hand, expects the 30-year bond futures to drop to the low 140s by the end of October and 10-year note futures to drop to around 118.
He apparently has been listening to the other voices that insist the Fed will not act. Although he is on the other side of the fence, he is not sure a rate hike won’t rile the markets.
“If we get an actual rate move, it will be interesting to see if [the market] can bear the brunt of it, or if we see [the market] down three handles (limit) four days in a row based on it, which I think we could,” Enerson says. “It is nowhere close to being priced into the markets. Not at these levels. People who continue to be bullish on the market have become numb to the idea of a rate hike. Everyone thinks it is talked about but will never happen. It is going to happen one of these days — I think September — and we will see how the bond market handles it.”
Lazzara’s uncertainty is not simply an outlier as the actual Fed funds futures market is pricing in (as of Aug. 11) a slightly less than 50% chance of a move in September, and only is pricing in one 25-basis-point increase in 2015 (see Listen to the market,” below).
“I am a little puzzled by Fed funds futures because if you pull up the consensus among economists it is about an 80% [chance] that they will raise rates,” Jones says. “But if I pull up one-year forward swap rate, it is higher. The one-year rate is 1.33%, a lot is built in. It should be a big surprise for the market but I do think that the yield curve will flatten,” he says.
Why has the Fed been able to maintain a zero-interest-rate policy for so long? The answer is a lack of inflation. Despite the dire warning many pundits voiced that QE1, QE2, operation twist and QE3 would lead to massive inflation, it hasn’t happened.
“I don’t think that is a risk anymore,” says Wilkinson. “Those who put forward that [inflationary] view have suddenly seen the light and realized that is not playing out. They were very simply wrong, it is that simple. They just made a knee-jerk reaction that the Fed was simply printing money and literally dropping it from a helicopter and too much money would be chasing too many goods and they were absolutely wrong in their comprehension of what quantitative easing stood for, what it was and what the transmission mechanism was. Bernanke educated the market on that. There were too many people panicking.”
Enerson says inflation needs to occur organically. “Using lower rates to produce inflation is not an effective tool. The lower rate picture as a crisis management tool has been abused on a global scale,” he says. “It is one thing when you are at 4% and you cut a half a point to inject liquidity; but if you are at zero or 0.75%, to cut another quarter is not going to have the effect you desire from an inflationary standpoint.”
He says inflation growth is not relevant to the interest rate picture. “Obviously this type of zero-rate environment doesn’t produce hyperinflation or any type of inflation because we haven’t seen it happen. It needs to happen organically. It needs to happen from policy that favors business through organic growth in the economy. Easy money doesn’t have much of an effect when it’s [below 1%].“
The problem is that even though the jobs picture has improved dramatically with the unemployment rate at 5.3% — a level once considered to meet the Fed mandate of full employment — wage growth has been stagnant.
“The Fed is satisfied with the actual job growth, they are satisfied with the rate of unemployment; they are somewhat flummoxed by the fact that there is significantly good job growth but the wage growth is not following,” Enerson says.
So much so that the previous obscure Employment Cost Index (ECI) has been one of the most followed economic indicators (see “Key data points,” below). “That normally is a pretty innocuous data point [but] comes out [worse than expected and causes a [large] rally in the bonds.”
A spokesperson for the Bureau of Labor Statistics confirmed that the BLS has been receiving heightened interest in the ECI series. Its importance in terms of Fed policy is clear as the Fed basically commissioned and pays for it, according to the BLS.
“You have to see a material shift in inflation to cause a bear market in bonds,” Wilkinson says. “Earlier in the year there was potential for a bear market in bonds if the Fed had moved quickly and repeatedly, but that sensation seems to have gone.”
He adds, “I am not sure that 10-year yields will rise above 2.5%, even after the Fed starts to tighten. That is going to be a bit of an acid test, that the 10-year yield remains under 2.5% at the onset of the tightening cycle. Normally it would be a pick-up in inflation, a pick-up in the economy and a pick-up in asset prices; generally, that would worry the market to shifting its emphasis on to the Fed’s next move.”
Most analysts see inflation as a potential problem down the road but not something that can be created by Fed policy. And that real inflation is what will eventually move yields.
“If we keep it at zero eventually inflation will go up — well, yeah — but if we raise it to 2%, eventually inflation will go up as well and we have a monetary tool back at our disposal,” Enerson says. “If we wait to raise rates until inflation actually takes off, it is probably too late and we are going to have an inflationary issue that we can’t necessarily rein in. And the Fed is starting to come to terms with that as well.”
“Wage inflation is minuscule,” adds Wilkinson. “We are going to need to see a significant pick-up in economic activity globally, particularly In China, for inflation to become any kind of threat. It is really hard to see anything.”
Another key issue is that with the economy six years into a recovery, there is the risk of an economic slowdown, and it would be nice if the Fed had the ability to move rates in either direction. More than one analyst suggested that it is important to get rates to 2% or so in order for the Fed to have the ability to cut them when the economy turns sour.
And while no one seems to see rising inflation as a serious risk, there still is this notion that the Fed could wait too long and will not be able to control it.
However, they are not without ammunition, even if they can’t move rates to equilibrium overnight. While no one expects the Fed to start selling off its massive Treasury assets, it is an arrow in their quiver.
“That portfolio that the Fed holds, that is going to be very supportive for the long end of the market,” McGuire says. “If and when inflation does rear its ugly head, the Fed would then use its portfolio in sizable chunks to let the market know that it is not going to let inflation get out of hand.”
Wilkinson doesn’t anticipate the Fed selling its book but acknowledges it is a tool in its arsenal. “[If] we did have a big problem with inflation, like energy prices doubling, I could see the use of its balance sheet to do the reverse of what it did — selling bonds and forcing yields higher.”
While inflation is not a big risk, a growing lack of liquidity has some worried. While the Treasury market has not had the problems of the corporate bond market, it experienced a flash crash of sorts last October and volatility has increased, particularly in spreads.
“No one is trading 30-years, it’s way too volatile,” Enerson says, pointing out a huge divergence in the 10-year note/30-year bond spread (NOB). He says that there is less liquidity and traders can no longer trade the NOB because of the volatility (see “Volatile spreads,” below).
“There has been an uneasiness tied to the uncertainty of when the Fed will act,” says McGuire. “Once they decide to pull the trigger, analysts will have a road map as to what the Fed will do going forward. And it doesn’t matter that ‘analyst A’ or ‘analyst B’ have different [projections]; they both will be confident in their analysis and that certainty will lend confidence to the market.”
More importantly, that confidence will bring people back to the market. “After that, some liquidity will return to the Treasury market. When the Fed moves, you will have all those model builders willing to project when the next Fed move will be and their confidence will grow, and with that confidence they will be more willing to take Treasury inventory, and their willingness to hold inventory will add liquidity to the Treasury market.”
Jones is not so sure. “I don’t think the uncertainly is hurting the economy,” she says. “There is this belief that low interest rates are somehow creating a bad environment — now, there is an element of continuing this misallocation of capital because money is cheap — but it is very hard to sit here with a straight face and say low interest rates are net/net bad for the economy when inflation is low. I don’t think this will cause some big upturn in the economy or cause capital spending to revive.”
Most analysts don’t expect huge moves in the bond market regardless of what the Fed does. “In terms of yields, if the front end goes up 50 basis points then the 10-year might go up 25 from here,” Jones says. “[Ten-year note yields] can be around 2.50% by the end of the year. [They haven’t] been able to get through that all year. ”
Lazzara agrees. “I don’t think it is going to be much different than it is now. You will see it go up, see it go down, but at the end of the day it is going to be right in the middle. I think we will be maybe 25 basis points higher than we are right now.”
McGuire says bonds may be higher, setting 165-170 as its high range. “There are still guys out there that think the Fed is going to have to go back to zero. That portfolio that the Fed holds will have a good influence on people wanting to bid Treasuries. They are going to have to go back, and when they do that everyone is going to want bonds. This is why I don’t think there is going to be massive selling.”
“I am struggling with the concept of a significant ratchet up in the yield curve given how gentle Yellen and the Fed has been on the lower end. They are going to extraordinary lengths to tell us that this is going to be a tightening cycle like no other,” Wilkinson says.
“I am struggling with the 10-year at this point breaching 2.5%; certainly 3% seems like a million miles away.“
While some analysts say the long bull market in bonds may be ending, it doesn’t necessarily mean a bear market. “Rates may have hit their lows in the 10-year back at 1.62%, but where are they going?” Jones asks. “It is tough to make a case for significantly higher yields in the next couple of years. We may be building a really big bottom in the bond market, but I don’t see a return to Treasuries in the 5% areas anytime soon.”
The variations of opinion on the market are understandable and given the extra period of Fed activity, relatively narrow. In a real sense the Fed has been making it up as they go along following the credit crisis of 2008. Massive intervention followed by six years of zero-interest-rate policy and three rounds of QE is hard to model. Despite all these measures, the market appears to be drifting toward the almost mythical soft landing often talked about. Seeing what Fed policy has gone through since the 2008 credit crisis, that would be a remarkable feat.