What The Fed’s Latest Statement Means For The Bond Market [iShares Barclays 20+ Yr Treas.Bond (ETF)]

market bondsAs my colleague Rick Rieder pointed out last week, there’s a lot of debate among market watchers about whether the Federal Reserve (Fed)’s most recent statement was hawkish or dovish. To recap: its stance on the economy 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

chart_Fed Funds

Investing Considerations

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.

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