Last week, the Federal Reserve (Fed) dropped its promise to be “patient” in raising interest rates, though it seems patience is just what the bond bears that have been calling for more rapid, more dramatic increases will need. While patience is out of the Fed’s lexicon for now, most of the Federal Open Market Committee’s (FOMC) statement, including its economic and interest rate projections, was dovish.
The probability of a June increase has diminished; September is now getting the nod for the start of monetary policy normalization, which will likely take a long time to accomplish. The Fed included new language; it wants to be “reasonably confident that inflation will move back to its 2% objective over the medium term.” The Fed-speak interpretation is that the strong dollar is keeping a lid on inflation and making U.S. products less competitive, potentially dragging on the economy. The rate path “dots” (below) have come down considerably. The median expectation of FOMC officials is for the fed funds rate to rise to 0.625% in December, down from the previous forecast of 1.125%. The implication is that there could be a rate move at every other meeting beginning in September.
Implications for bond investors — know the role
Core bonds remain a key ingredient for diversifying balanced portfolios. While core investment grade bonds will not likely see significant price appreciation, they can be an important source of ballast during periods of heightened uncertainty and market turbulence. Forecasting interest rates is a tough business, and just getting the direction right has proven difficult. In April 2014, the 10-year Treasury yield was 2.7% and the consensus was calling for a yield increase. In fact, not one of the 67 economists surveyed by Bloomberg predicted it would be lower by the end of the year, yet on December 31, 2014, the yield stood at 2.17%.1 Consensus is once again on the wrong side in 2015, anticipating rising rates even as the yield wavers below 2%. Money managers who played it short and safe in duration last year were left watching as the Barclays Aggregate Bond Index chugged higher. While “lower for longer” is getting long in the tooth, it appears to still ring true for the immediate future.
Now is not the time to abandon core bond exposures for fear of rising interest rates. While we remain underweight in the asset class, bonds provide an element of insurance amid unpredictable markets. We maintain modest tactical tilts toward high yield bonds, floating rate notes and opportunistic strategies that offer the potential to better weather a rising rate environment.
1 Source: Bloomberg, April 2014