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11.12.2015 | 15:43

What happens once interest rates lift off?

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

Rate risk mispriced?

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 a low interest rate environment to 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.

Gauging the Fed

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.

Trouble with the curve

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 could present an attractive opportunity to active fixed income investors. In such an environment shorter dated bonds would likely underperform those with longer maturities.

Positioning for the hiking cycle

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 it tightens monetary policy slowly and gradually.

Author: Michael Lake, Investment Director, Fixed Income