and rates were mostly unchanged from the prior meeting. It indicated that it will keep its target rate between 0 and 0.25% for a “considerable amount of time” while continuing to taper its bond buying program, cutting monthly purchases to $15 billion. The market expects that the fed will officially end its bond buying program at their October meeting. Rick’s post on the subject made the case that there are a number of signs that a Fed rate hike could be on the market sooner rather than later.
So how is the market reacting to the news? As I noted in my prior post on this topic, the Fed includes in their statements the projected level of the fed funds rate as indicated by individual FOMC members. This provides forward guidance to the market, helping us to have a better understanding of when the Fed might begin to move and at what pace short rates might rise. We’ve seen that the market tends to believe the Fed will move more slowly than what is indicated in their guidance.
A recent article by the San Francisco Fed supports this observation, as the market has been pricing in rate movements below Fed projections since January 2012. We can also see this in the fed funds futures market, where contract value is tied to the level of the fed funds rate at a future point in time. Below is a glimpse of the latest fed funds rate projections from the September meeting compared to the current level of the fed funds rate priced into the futures market.
Fed Funds Rate Projection from the Fed versus Fed Fund Futures Market, July 2014-2017
The discrepancy between market and Fed rate expectations has short- and long-term implications for investors. First, they should be aware that the gap between the Fed’s rate guidance and the futures market may be reconciled, but it’s too early to tell which will move and when. Given this uncertainty, we remain cautious on Treasuries with 2 to 5 year maturities as they may re-price quickly if the Fed’s tone changes. I’ll also be paying close attention to the Fed’s October statement for any indication that a rate increase is near.
Longer term, when the Fed does start to raise rates, some investors will likely move out of fixed rate bonds and into floating rate notes, such as the iShares Floating Rate Bond ETF (FLOT). Coupons on floating rate notes reset with changes in a short-term interest rate, such as LIBOR. During the last tightening cycle, floating rate notes outperformed fixed rate bonds as measured by the Barclays U.S. Aggregate Bond index and also exhibited less volatility. This has historically made floating rate notes a popular investment during Fed rate hikes.
Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
For actual iShares Fund performance, please visit www.iShares.com.*
Sources: Barclays and Bloomberg as of 12/31/2013.
Coupon reset is for illustrative purposes only.
* Standard deviation measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile.
©2014 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares ETF and BlackRock Mutual Fund prospectus pages. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.
The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).
The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Market Indices Limited.