FOMC Watch: Float Like a Butterfly, Don’t Get Stung by a Bee

kevin-temp2
05/02/2018

The results of the May FOMC meeting are scheduled to be released at 2 p.m. Eastern time today. The usual accompanying policy statement will be made available, but there will be no economic projections or press conference this time around. The expectation is for no rate hike at this convocation.

 

As of this writing, the markets placed only a 34.2% chance for another rate increase at this meeting, according to the Fed Funds Futures implied probability figure. This is not a reflection of any shift in Federal Reserve (Fed) attitudes, as additional rate hikes are still anticipated for later this year and into 2019. To provide perspective, the implied probability for the June 13 gathering stands at 92.0%, underscoring the fact that another move is widely expected. In fact, a total of two further tightening moves for 2018 are fully priced in at this point, and depending upon how upcoming data comes in, there is still a debate about whether three additional hikes could be forthcoming. For the record, the Fed’s latest “blue dots,” or its in-house projections for the Federal Funds Rate, looked for two more increases this year and three hikes in 2019. In fact, the Fed also estimated that it would continue to raise rates twice in 2020, but let’s not get too far ahead of ourselves.

 

What Should Fixed Income Investors Focus On?

 

The second leg of the rise in the U.S. Treasury (UST) 10-Year yield came rather abruptly, and with a notable milestone. In the most recent two-week span, the yield jumped 25 basis points (bps), breaching the 3% threshold in the process. While we could all debate where we think the 10-Year yield is headed from here, there appears to be one crucial point not really up for such conjecture: The Fed is expected to continue raising rates.

 

Against this backdrop, investors should be considering strategies to address this potential outcome, as some Fed protection seems warranted. In our opinion, an optimal solution is the 2-Year Treasury floating rate note (FRN) space. The interest rate for an FRN “floats” or gets reset at the weekly 13-week t-bill auction. As the Fed raises rates, the rate hike is reflected in this t-bill auction, not only offering investors a rate hedge for their portfolios, but also providing the opportunity for higher yield enhancement.

 

UST FRNs vs. CDs

 

Some market participants may believe that certificates of deposit, or CDs, are a better solution. However, there are some important items to consider. First up, UST FRNs are backed by the full faith and credit of the U.S. government. CDs are insured by the Federal Deposit Insurance Corporation (FDIC), but only up to $250,000 per person, per bank, per ownership category.

 

Let’s look at it from an income perspective. The WisdomTree Bloomberg Floating Rate Treasury Fund (USFR), which seeks to track the price and yield performance, before fees and expenses, of the Bloomberg U.S. Treasury Floating Rate Bond Index, posts an average yield to maturity of 1.81% as of this writing. According to Bankrate, formerly known as Bank Rate Monitor and a provider of various interest rate data, the top five rates for six-month CDs post an average of 1.86%, while the national average for a one-year CD is 2.10%.

The bottom-line message is that there is only a marginal increase in yield, but perhaps more importantly, investors would have to lock up these CD rates for a six-month and/or one-year period. Meanwhile, the yield for a UST FRN can be reset weekly. When one considers the fact that the Fed may be raising rates two if not three more times between now and year-end, USFR offers investors a better opportunity for more timely yield enhancement.

 

Unless otherwise noted, all data is Bloomberg as of April 27, 2018.

Important Risks Related to this Article

For the standardized performance and 30-Day SEC yield of USFR, please click here

 

Performance is historical and does not guarantee future results. Current performance may be lower or higher than quoted. Investment returns and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Performance data for the most recent month-end is available at wisdomtree.com.

 

WisdomTree shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Total Returns are calculated using the daily 4:00 p.m. EST net asset value (NAV). Market price returns reflect the midpoint of the bid/ask spread as of the close of trading on the exchange where Fund shares are listed. Market price returns do not represent the returns you would receive if you traded shares at other times.

  

There are risks associated with investing, including possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

About the Contributor
kevin-temp2
Head of Fixed Income Strategy

As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.