What’s Happening in the Interest Rate Markets
The Federal Reserve Bank holds official meetings eight times a year. They are called the Federal Open Market Committee (FOMC) meetings. The meetings are attended by Chairman of the Fed (Ben Bernanke) and other participants, including Fed Governors and Reserve Bank presidents. It’s at these meetings that interest rate policy is determined. Currently, the Fed is keeping interest rates very low by:
- Targeting the Fed Funds Rate essentially at zero (ZIRP or zero interest rate policy)
- Purchasing bonds in the open market (QE or quantitative easing policy)
The goals of interest rate policy are to keep unemployment low and inflation under control. The Fed has been deploying these policies for four years running and will continue to do so until unemployment is under 6.5% or inflation is over 2.5%. Neither level is close yet to being achieved.
Three weeks after each meeting the FOMC releases its official minutes and Bernanke testifies before Congress on the state of the economy and the Fed’s policies. It was Bernanke’s testimony on May 22nd that has interest rates moving up. See the chart of the interest rate of the 10 Year US Treasury Note below:
As you can see, in the last month the 10 year interest rate has moved from 1.65% to 2.15%. What did Bernanke say to spark this move? I think his commentary in the Congressional Q&A was what did it. Below is what he said:
- “As the economic outlook – and particularly the outlook for the labor market – improves in a real and sustainable way, the committee will gradually reduce the flow of purchases”
- “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases”
Because of these answers, some investors in the bond markets are sensing that QE bond buying by the Fed will be winding down quickly, perhaps by the end of the year. If or when this happens interest rates will rise further. In my opinion I think Fed monetary policy (QE3) will continue well into 2014 at full or partially reduced levels. I also believe the Fed will exit their QE programs in an orderly fashion, over time, that won’t be disruptive to the markets.
Regardless of when the Fed pulls back on QE3 bond buying, the market is anticipating a reduction and has reset interest rates higher. As we all know, when interest rates go up, bond prices go down. This is why we’ve seen slightly negative performance in the bond markets in May.
Bond prices are not the only asset class that gets hurt. Stock sectors that have higher dividend yields also correct as the dividends they pay are less attractive in a higher interest rate environment. Look at the year to date Utility and REIT sector charts below, they’ve also had quite a correction.
The Utility Sector:
The REIT Sector:
Wayne Schmidt (Chief Investment Officer at Gradient Investments) has been discussing the possibility of losses in the bond market for some time now and has warned us all to expect lower single digit returns in the fixed income markets for 2013. To protect ourselves from a rising interest rate environment we use the following strategies:
- Laddered Income Portfolios (bonds are held to maturity)
- Senior Bank Loan Portfolios (interest rates are reset every 3 months)
We’ll continue to monitor Fed policy, interest rates and the fixed income markets to asses if there is any reason to change our forecasts or portfolio strategies.
As of June 3rd, 2013:
Dow Jones US Moderately Conservative Index is up 6.22% (TR) for the year
S&P 500 closed at 1,640.42 up 16.07% (TR) for the year
U.S. 10 year Treasury Futures are yielding 2.14% up 0.38% for the year
WTI Crude Oil futures closed at $93.45 up $1.60 for the year
Gold closed at $1,412 per ounce down $263 for the year
To expand on these market reflections or discuss other portfolio strategies please don’t hesitate to reach out to the Gradient Investment team.
