Will Interests Rates Rise In 2013?

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December 17, 2012 12:24pm NYSE:IEF NYSE:TBF

Matt Tucker: When the Federal Reserve met this week, it announced that it would keep the target for its key interest rate near zero until the unemployment rate improves or inflation picks up. As MarketWatch remarked after the announcement, “Fed policy

has now become an open book, as predictable as the tides.”

It is true that with these announcements, investors are getting an unprecedented new level of transparency from the Fed. The Fed said it is looking to keep a lid on rates until unemployment, which stands at 7.7%, falls to 6.5% or lower. This is the first time it has stated an economic target. Since the Fed has a dual mandate for price stability and full employment, it is also watching for inflation to climb up to 2.5% from its current annual rate of 1.8%. Meanwhile, the Fed is extending its stimulus program, saying it would buy $45 billion in Treasuries and $40 billion in mortgage-backed securities each month.

At this point, the federal funds rate has been close to zero for four years. But as we head into 2013 and investors look to position portfolios, many are asking whether next year might be the year when interest rates begin to rise. After all, the Fed doesn’t actually set interest rates; rather it tries to influence them through its monetary policy.

Earlier this year, we identified three major factors that were helping to keep a lid on rates:

1.)   US economic growth and inflation were holding steady at moderate levels.

2.)   There was heightened demand among investors for perceived “safe-haven” investments like US Treasuries given the European debt crisis and larger macro uncertainty.

3.)   We continued to see buying of US Treasuries by non-price sensitive buyers such as the Bank of Japan, the Central Bank of China and the Federal Reserve.

As we head into 2013, all three of these forces remain in place. Gross domestic product has grown at a moderate rate of 2.5% year-over-year with inflation readings falling inside the Fed’s target range. Investors continue to look to US Treasuries when markets get rocky (and there are still plenty of rocks out there). And central banks around the world are still active buyers of US government debt.

The most recent announcement helps add clarity to investors’ signposts of rising rates. Because the Fed is explicitly targeting an unemployment level with a limit on inflation, investors now have specific indicators to watch to gauge whether rates may head higher.

Another indication that rates might rise? Less demand for Treasuries, either from central banks or other investors. A reduction in purchases by the Fed or other banks could remove significant buyers from the Treasury market, sending prices lower (and rates higher). Also, if we to see a positive resolution to the ongoing fiscal crisis in Europe and cliff in the US, it could spark increased demand for higher risk assets and a sell-off of US Treasuries. But until any of these events happen, talk of rising rates is likely premature.

The bottom line is that as we head into 2013, we are unlikely to see a significant increase in rates, at least in the near term. The factors that kept interest rates low throughout 2012 appear to be very much in place as the clock ticks down to the New Year.

ETF DN Related Tickers: ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT),  iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF), ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF), iShares Barclays 20+ Year Treas Bond ETF (NYSEARCA:TLT).

Written By Matthew Tucker From The iShares Blog

Matthew Tucker has spent the past 16 years focused on fixed income analytics, portfolio management and strategy. As managing director of U.S. fixed income strategy at BlackRock, Inc., and a member of the Fixed Income Portfolio Management team, Mr. Tucker leads both product strategy for ETFs and North America and Latin America iShares strategies, as well as product delivery and client sales. He previously worked with Barclays Global Investors before it merged with BlackRock, and he led the U.S. Fixed Income Investment Solutions team responsible for overseeing product strategy for active, index, enhanced index, iShares and long/short products. Mr. Tucker was also a portfolio manager and a trader in fixed income focused on U.S. government securities.

He began his career at Barra, where he supported clients using the company’s fixed income analytics. Mr. Tucker holds a bachelor of business administration degree from the University of California, Berkeley, and is a Chartered Financial Analyst charterholder.

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