The Federal Reserve and Rising Rates

With the recent spate of positive economic news, highlighted by the strong jobs numbers for both October and November, all signs point toward the Federal Reserve raising the federal funds target rate 25 basis points from 0–0.25 percent to 0.25–0.50 percent. Based on federal funds futures, the market is assigning a roughly 76 percent probability of a federal funds increase. Given that this would be the first interest rate hike by the Federal Reserve since 2006, many clients are beginning to ask, “Should we stay short and wait for the Fed to raise interest rates before investing?”

Investors need to remember that fixed income markets, just like equity markets, incorporate all known information into bond prices. If investors know the Fed is highly likely to raise the federal funds target rate at its December 16 meeting, then that information should already be priced into the market today. To see this at work, take a look at the federal funds futures market as well as the yield on the 2-year U.S. Treasury bond. At its meeting on October 28, the Federal Open Market Committee opened the door for a possible December rate hike with the following statement: “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress — both realized and expected — toward its objectives of maximum employment and 2 percent inflation.” Before this announcement, federal funds futures were predicting a 35 percent chance of an interest rate move in December while the 2-year Treasury rate sat at 0.65 percent. After the announcement, federal funds futures jumped to a 57 percent probability of an interest rate move while the 2-year Treasury yield increased eight basis points to 0.73 percent. As you can see, the market was able to digest this information and price it in rapid succession.

Now that we know a likely rate hike has already been priced into the market, we can answer the question of whether we should stay short and wait for interest rates to rise. The answer is a resounding no. Because this information has already been priced into the market, the only way an investor could profit by staying short is to know that interest rates will either rise faster or higher than the market is currently anticipating.

To illustrate this concept, look at forward interest rates. Let’s say a 1-year Treasury currently yields

0.57 percent while a 2-year Treasury yields 0.94 percent. If you were to invest in both securities and hold them for one year, you would have to reinvest the money in the 1-year Treasury at a yield of 1.30 percent just to break even with the original 2-year Treasury. The market is telling investors that it anticipates the

1-year Treasury to yield 1.30 percent one year from now. Again, the only way it’s profitable for investors to stay short or to wait is if they know the 1-year Treasury yield will be higher than 1.30 percent next year.

Academic evidence shows that no manager can persistently time the fixed income markets. We continue to recommend constructing a high-quality fixed income ladder that will protect client assets in both a rising and falling interest rate environment.

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