Why the Bond Market is Reacting Calmly to the Fed’s Latest Rate Hike | Capital Group

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Why the Bond Market Has Absorbed Fed Rate Hikes So Well

By Mark Brett and Margaret Steinbach

The Federal Reserve’s latest interest-rate hike underscores that the current tightening cycle is unprecedented in ways that are encouraging for investors. The Fed raised its short-term interest rate target by a quarter-point to a range of 1% to 1.25% on June 14. The hike is the fourth in this cycle, signaling that the central bank’s tightening campaign is now well underway. We expect one more rate hike this year and for the Fed to begin winding down its balance sheet late in the year. However, we do not believe these actions should be a cause for concern among bond investors.

As bonds yields rise, prices fall – that’s just how bonds work. But while that rule always holds, it does not mean bond investors are headed for trouble in the current tightening cycle. Monetary policymakers are raising rates very gradually to limit potentially negative impact on the economy. 

To understand how unusual this cycle is, consider how the Fed proceeded during the last such period, which began in June 2004. Over the 18 months that followed, the Fed boosted rates aggressively – to 4.25% from 1%. Two big features are different this time. Today the Fed is starting from a lower level (from between 0 and 0.25%). More than that, during the first 18 months of this cycle the central bank has pushed up rates by only 1% compared to 3.25% in the last round.

We believe this strategy of gradual rate hikes is likely to continue. This is in part because the Fed is also interested in tightening monetary policy by gradually reducing assets on its balance sheet, — assets that it purchased to provide liquidity in the markets during the financial crisis of 2008-09 and to stimulate the U.S. economy through 2014. After another hike this fall, we don’t expect another rate increase until next year, as the Fed will instead likely move to begin letting assets on its mammoth $4.5 trillion balance sheet run off. Since the financial crisis, the Fed’s balance sheet has grown five times as the central bank bought a combined $3.5 trillion in U.S. Treasuries and mortgage-backed securities to boost the U.S. economy by keeping interest rates low.

Long-Term Rates Should Remain Anchored

Investors should also remember that the Fed only has direct control over short-term rates. Longer-term rates are dictated more by market forces. Indeed, this is why the benchmark 10-year Treasury yield has hovered around the relatively low rate of 2.25% for the past six years, despite recent short-term rate hikes. So while short-term rates have increased by 1% over 18 months, the 10-year Treasury yield is roughly unchanged over the same period.

We think longer term yields should remain fairly low for an extended period, even as the Fed continues raising short-term rates, for several reasons:

  • The U.S. continues to grow at a muted pace of roughly 2%.
  • Global growth and inflation remain low, and global central bank policy is still very accommodative.
  • Foreign investors continue to exhibit strong demand for U.S. bonds, as their local fixed income issues provide lower yields than U.S. bonds.
  • In today’s uncertain environment, there are many potential sources of risk, such as those stemming from fiscal and monetary policy uncertainty, and possible geopolitical shocks that could result in a flight to quality and increased demand for U.S. bonds.
  • As rates increase, so does demand for bonds from key groups of investors, which helps to limit how much yields can rise. Those include mutual funds, pensions and insurance companies.
  • Many fear that the Fed could have more impact on longer-term rates as it begins to shrink its balance sheet. However, we do not find this likely. Based on how the Fed outlined its likely procedure for balance sheet reduction in its May meeting minutes, it will do so gradually and methodically, allowing a limited amount of Treasury and mortgage securities to run off each month. Currently, the Fed reinvests all proceeds of maturing bonds into additional bonds in order to maintain the size of its balance sheet.
  • By providing a ceiling, or a cap, on the amount of bonds that are allowed to mature without reinvestment, the Fed will provide a smooth path for ending its reinvestment to avoid an abrupt reduction of its balance sheet. Any amount that matures above the cap will continue to be reinvested by the Fed. The cap would initially be set at a low level and raised every three months until the balance sheet size is normalized. Even at that point, it will remain historically large at $3 trillion, according to baseline projections.

Income Could Overshadow Price Declines

With the Fed hiking short-term rates, some investors fear that bond returns may be more negatively impacted by rising yields than they have been in past cycles. Although bond math holds that bond prices fall when yields rise, the coupon earned can help to offset declines from rising yields. The ability to reinvest at higher yields also helps to offset price declines from rising rates. It’s not only about how much interest rates rise, but also about how they rise relative to the forward curve, and whether yields rise, as longer-term yields may or may not react to higher short-term rates. For all these reasons, bond returns are often able to prove resilient in the face of Fed rate hikes.

Mark-Brett-200x200

Mark Brett is a fixed-income portfolio manager based in London. Mark has 38 years of investment experience, 23 with Capital. Prior to joining Capital, Mark was an economist and strategist with Barclays in London.

Margaret-Steinbach-200x200

Margaret Steinbach is a Capital Group fixed-income specialist in Los Angeles. Margaret has 10 years of investment industry experience and joined Capital Group in 2015. Prior to Capital, Margaret worked as a portfolio specialist at Oaktree Capital Management.

The views expressed herein are those of the author and do not necessarily reflect the views of everyone at Capital Group Private Client Services. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, are subject to change at any time and should not be construed as advice. There is no guarantee that any projection, forecast or opinion will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor.