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What happens once rates have gone up?

08/12/2015

Michael Lake

Investment Director, Fixed Income

Expectations that the Federal Reserve (Fed) will raise interest rates have increased markedly following the October Federal Open Markets Committee (FOMC) meeting, but what does this mean for bond investors?

With over 80% of the market now expecting the Fed to hike rates by 25 bps at their December meeting, investors appear increasingly confident that a tightening cycle will be initiated next week. However, investors still expect that a low interest rate environment will continue, not just in absolute terms, but also relative to the Fed’s own expectations.

Arguably the market’s pervasive ‘dovish’ expectations are the consequence of a confusing communication policy from the Fed themselves, who have been seen to move the goal posts on a number of occasions this year. Even so, the under-pricing of interest rate risk by the market remains pronounced and out of sync with economic data. US employment remains low, GDP growth is positive and the impact of the lower price of oil on US inflation is diminishing.

It appears that the market has overlooked the potential impact of a rate hike beyond December because it has had such a tough time gauging when the Fed’s first hike will be. If the Fed does hike rates, then interest rate expectations across the yield curve will need to be reassessed. Today, the Treasury curve remains too steep. Markets are not pricing in enough interest rate premium in the near term; i.e. short dated bonds do not currently compensate adequately for the risk of a rise in rates. We believe that as interest rate expectations change, so too will the shape of the yield curve.

Looking back over the Fed’s previous three rate hiking cycles, the yield curve has flattened substantially following a rate rise, as short term interest rate expectations were revised upwards. Given that the market is currently under-pricing the extent to which the Fed can hike rates, we believe a yield curve flattening strategy presents an attractive opportunity to active fixed income investors as in such an environment shorter dated bonds would likely underperform those with longer maturities.

Looking to life after the first rate hike, the path to a truly normalised rate environment may prove to be more volatile than investors and the Fed currently expect. The Fed is targeting a so-called ‘dovish’ series of rate hikes, where they tighten monetary policy slowly and gradually. The market is banking on the Fed being even more dovish than that. However, historically the Fed has needed to hike rates more aggressively than even they currently predict, and based on current pricing the market is not positioned for this.

Accordingly, we believe that underweight US interest rate exposure (duration), with a yield curve flattening bias, offers an opportunity to exploit strategic directional and relative value opportunities.

Further tactical opportunities may also appear as the market adjusts to higher interest rate volatility.

Author

Michael Lake

Investment Director, Fixed Income

  Michael Lake