How to learn not to worry about rates and love the Fed
Long-term bond yields that offer a greater cushion against higher rates than previously, and demand for fixed income from a burgeoning number of retirees also suggest the inevitable sell-off forecasters have predicted is less likely.
If you’re concerned the Federal Reserve will derail the bond market when it finally starts raising interest rates, the last two tightening cycles suggest those worries may be overblown.
Instead of tumbling, U.S. debt securities from Treasurys to junk bonds gained. They returned an average 5.7 percent between June 2004 and June 2006, when the Fed lifted rates to 5.25 percent from 1 percent. In the seven months ended January 2000, bonds retained their value even as benchmark borrowing costs increased 1.75 percentage points.
With the U.S. economy expanding at a slower pace and less wage growth to pressure inflation, there are fewer reasons for the Fed to raise rates as quickly this time as the central bank moves to end six years of unprecedented stimulus.
Long-term bond yields that offer a greater cushion against higher rates than in previous cycles and demand for fixed income from a burgeoning number of retirees also suggest the inevitable sell-off forecasters have predicted is less likely to materialize.
“It would be a mistake to bet against the bond market,” said Priscilla Hancock, global fixed-income strategist at JPMorgan Asset Management, which handles $1.5 trillion. “The road to higher rates will be a long, slow march at a time when income is the most important thing. That means fixed income will still be an important place to be.”
In the U.S., debt securities of all types have rallied this year, confounding forecasters’ projections for losses, index data compiled by Bank of America Merrill Lynch show. Their 4.14 percent average return is the biggest since 2010.
Yields on 10-year Treasurys, the benchmark for securities as varied as mortgages, corporate bonds and emerging-market sovereign debt, have fallen more than a half-percentage point to 2.45 percent at 12:30 p.m. in New York.
The debate over the Fed’s interest-rate policy and its effect on bonds has been intensifying as the central bank moves closer to ending its monthly debt purchases, which has helped inundate the U.S. economy with more than $3 trillion of cheap cash since 2008 and propped up asset prices.
The stakes have never been higher. In just six years, the global market for bonds has ballooned more than 40 percent to a record $100 trillion, according to estimates from the Bank for International Settlements.
There’s now a 60 percent chance the Fed, which has held borrowing costs close to zero since 2008 to restore a crippled economy, will start raising rates by next July,, futures contracts show.
Last month, the Fed itself predicted the target rate will rise to 1.13 percent at the end of next year and 2.5 percent a year later, according to the median projection of 16 policymakers. Based on their long-term growth outlook, they anticipate stopping once rates reach about 3.75 percent.
That indicates borrowing costs will increase less than in the previous cycle, when they climbed 4.25 percentage points, and rise at a slower pace than in 1999-2000, when rates ended at 6.75 percent, data compiled by Bloomberg show.
One reason is because the 5-year-long expansion is still showing signs of weakness. Last quarter, the world’s largest economy contracted 2.9 percent, the deepest drop-off since the 2009 recession.
Economists say growth will accelerate 3 percent next year when the Fed starts raising rates. That would still be slower than the 3.8 percent expansion in 2004 and fall short of the more than 4 percent pace in 1999 and 2000.
“The Fed approach is much more transparent,” which reduces uncertainty and risk, said Kathy Jones, a fixed-income strategist at Charles Schwab in New York.
A growing number of retirees and pensions are also buying bonds for steady, low-risk income in a demographic shift that’s set to underpin debt demand for years to come. The number of Americans 65 years old or more will increase 14.5 million this decade, the biggest jump versus the total population going back to 1900, data compiled by the Census Bureau show.
“There is tremendous demand for fixed income,” said Ed Keon, who helps oversee more than $100 billion at Prudential Financial’s Quantitative Management Associates. “And that doesn’t seem to be changing anytime soon.”