Let’s separate the commentary from the numbers, and explore what this may mean for you.
What Yellen Said
- Quantitative easing and the pace of asset purchases will depend on jobs and inflation levels. If the labor market continues to improve, and inflation remains muted, Yellen says “the Committee likely will make further measured reductions in the pace of asset purchases at upcoming meetings, with purchases concluding after the October meeting.” That makes October 29th the likely announcement of the end of the asset purchase program.
- The Fed will continue to take its time in increasing the federal funds rate. Yellen said that the Fed has “maintained the target rate for the federal funds rate at 0 to 1/4%” and will continue to monitor progress in the jobs market and inflation.
What the Futures are Saying
The end of the QE program has been largely anticipated by investors and its impact has already been priced into markets. Changes in the Fed Funds rate are another story. Futures data indicates that the Fed will likely move slower to raise the federal funds rate than they have indicated, and that the increase will be gradual. The market seems to be dubious about either the Fed’s outlook on growth or the speed at which they will move to contain it. Take a look at the below graph:
Fed Funds Rate Projection from the Fed versus Fed Fund Futures Market, July 2014-2017
Source: Bloomberg, Federal Reserve
Notice how there is general consensus on where fed funds should be at the end of 2014. But as we move into 2015 there is a growing disparity between the Fed’s indications and the market’s pricing. By the end of 2015 the median FOMC projection for the federal funds rate is 1.125%, while the market has priced in 0.775%. The bottom line, the market expects the Fed to raise short term rates more slowly than the Fed minutes would indicate.
What the Disconnect Means for Investors
This is a fresh reminder that for the near term the Fed and their actions are likely to remain the primary driver of markets, and especially short term interest rates. As we move closer to the first funds hike it is likely that we will see the difference cited above converge. Whether that means the Fed moving more slowly (or more quickly) than they anticipate, or the market expectations backing off is hard to say, but one way or another, we know the market and the Fed will converge. Because that adjustment has the potential to be volatile, and because the shorter end of the yield curve will bear the brunt of any increase in volatility, we remain cautious on 2 to 5 year maturities. Interestingly, the longer end of the yield curve may exhibit relatively lower volatility as the market and the Fed square off. While long-term investors should be aware of the potential for interest rate volatility, they should keep in mind that their returns will ultimately be driven more by coupon income and the reinvestment of that income.