However, markets are running contrary to the direction that the US Federal Reserve (Fed) has signalled so far.  Members of the Fed have emphasised that they are explicitly committed to achieving maximum employment. They have pledged to hold off any policy rate increases until realised inflation has reached 2% and is on track to average 2%.

Fed chair Jay Powell has dismissed any possibility of tapering asset purchases in 2021. He expects inflation to remain contained and that it could take three years to reach the 2% average inflation target. Powell and other members have been forceful and consistent in adhering to this policy framework.

The so-called median dot plot, in which individual Fed officials map their forecasts for interest rates, released for the March 2021 meeting of the Federal Open Markets Committee, showed policymakers did not expect the first rate rise until at least the end of 2023.

Yet bond markets have in recent weeks radically brought forward the market-implied expectations of the timing of the Fed’s first rate increase. That first move is expected by the end of 2022, according to current market pricing.

Three questions for Ken O’Donnell, head of short duration fixed income

What is the situation on US fixed income markets now?

Let’s first consider the context. Central banks’ accommodative monetary policy has left investors with very little if anything in terms of return potential on bank deposits, money market funds and ultra-short and short duration bond mutual funds. While the absolute yield in the US may be positive, in inflation-adjusted terms, returns are negative. A negative real return means your capital is not keeping pace with inflation. Its purchasing power is slowly eroding away.

How long will this last? After the global financial crisis of 2008/09, interest rates remained low for six years in what in Fed speak was an extended period. That was a difficult period for risk-averse investors. The good news is that such a long period of low real interest rates does not appear likely this time. The US economy is responding to the measures taken.

Nevertheless, the Fed’s forecast is for no rate increases until 2023.

When should we expect official interest rates to rise?

In my opinion, the balance of risk is tilted towards a move sooner. A strong rebound in growth and a corresponding decline in unemployment would pressure policymakers to begin to remove stimulus measures.

That would put an end to (near) zero rates sooner than expected.

We could expect to begin to see a gradual shift in Fed rhetoric by June, acknowledging that the economy is performing well. This would put the Fed schedule for a tapering of asset purchases under its quantitative easing policy accommodation programm at year-end and into 2022. A potential
increase in the fed funds rate would then come by the end of 2022.

How should bond investors position themselves for this scenario?

There are various considerations.

Intermediate 10-year US Treasury note yields have risen by 100bp from the low of August 2020 to 1.65% (see Exhibit 1 below). That is a 9% drop in the market price of these notes. This is painful when you are receiving less than 1% in annual interest. Bond investors face a permanent loss for this market cycle, but they should keep in mind that this loss comes after a long period of excess gains of about 10%. In a way, compensation for bond risk is averaging out.

In addition, with T-note yields now near 2% levels, investors may choose to rotate out from investment-grade and high-yield corporate bonds into the US Treasury market. This could cause credit spreads to
widen.

Managing through this – markets pricing in higher rates is likely to continue – will be challenging. The Fed will need to respond to the recovery and begin the rate normalization cycle and if the recovery proceeds more rapidly, the market adjustment could be quite extreme. That is not our base case, but we still think there are benefits to adopting a flexible investment strategy.

This would involve a regular reassessment, reinvesting every quarter. An investor using such a disciplined ‘ladder’ strategy (see Exhibit 2) invests in bonds ranging in maturity from short term to long term and reinvests the proceeds when a bond matures.

Exhibit 2: A
laddered bond portfolio disperses risk in a ladder-like fashion, mitigating interest rate risk, reinvestment risk, credit risk, and liquidity risk.

Source: Corporate Finance Institute via https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/laddered-bond-portfolio/

If the short-term bonds mature at a time when interest rates are rising, the principal can be reinvested in ‘higher-rung’ bonds. It mitigates interest rate risk, reinvestment risk, credit risk, and liquidity risk.

Such a diversified portfolio has greater liquidity, allowing the investor to participate in the rising yield pattern and capture yield over time rather than trying to time the market by waiting for peak yield.

Originally Appeared On: https://investors-corner.bnpparibas-am.com/markets/bond-investors-beware-us-rates-may-rise-sooner-than-thought/