In recent research released by the Federal Reserve Bank of San Francisco and echoed in statements by several Fed regional bank presidents, Fed officials have voiced concerns that the market is underestimating the probability and timing of a change in monetary policy
If previous market cycles are any indication, heavy positioning and an earlier-than-anticipated tightening
cycle by the Fed could leave many investors vulnerable to a shift in policy.
In today’s market, two- year Treasury yields
are anchored near 0.50%.2
We believe it is possible that yields could breach 1% for the first time in nearly five years in anticipation of the first Fed rate hike. Absent other factors, this could result in a loss in price terms from current levels of approximately 1%. While not a devastating loss, it does significantly raise the prospect of negative total returns in this part of the yield curve
given the current low levels of income potential.
As we explore below, from a timing perspective, Morgan Stanley has determined that during the most recent tightening cycle of 2003–2004, markets began to price in a change in Fed policy approximately six months before the actual change.3
With current forecasters calling for the first rate hike in mid-2015, we believe that now may be a prudent time to reduce interest rate risk
in anticipation of this shift in policy.
Yields and Total Returns of 2-Yr Treasury Notes during Past Tightening Periods- Yield and Rate Levels
For definitions of terms and Indexes in the chart, visit our glossary.
While today’s path to tightening is in many ways unprecedented, we believe looking at past tightening periods can provide valuable insight into the possible future path of rates. The most significant difference between today’s markets and past periods is the initial level of interest rates. In each of the three previous tightening periods, much higher yields provided a sizable cushion to offset losses related to lower bond prices as interest rates rose. For example, two-year Treasury yields rose by 103 basis points (bps)
in the six months preceding the first Fed rate hike in 2003. In 1998, rates rose by 102 basis points.4
However, in both instances, total returns remained positive given the higher starting levels of yields. While it is noteworthy that rates rose by approximately the same amount in the six months preceding the first rate hike during the previous two cycles, we do not believe this will necessarily occur in 2015. This view is primarily driven by our outlook not only for the timing of the first rate hike, but the pace of subsequent hikes and the ultimate “neutral” policy rate.
The other interesting element of the table above relates to the total returns for the two years over each of the previous tightening cycles. While the duration
and starting yield levels of each tightening period differ greatly, the total returns from each period are remarkably similar at approximately 3%. In higher-rate environments, the duration of the tightening cycle has historically been shorter. In the most recent tightening cycle, from 2003 through 2006, the longer period of tightening allowed bond investors to recoup losses through higher levels of income.
While we don’t anticipate that the pace of Fed tightening will be as aggressive as the periods seen in recent history, we do believe that in each previous period, the market underestimated the timing of a shift in policy. However, during previous periods, starting yields were significantly higher, thus increasing bond investors’ margin of error. In our view, given the current low levels of income potential, the prospect of negative returns from short-duration fixed income remains at much higher levels than in past tightening cycles.
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Source: Jens H.E. Christensen and Simon Kwan, “Assessing Expectations of Monetary Policy,” Federal Reserve Bank of San Francisco, 9/8/14.
Source: Bloomberg, as of 8/31/14.
Source: Morgan Stanley, 6/9/14.
Sources: Bloomberg, WisdomTree.