How to Learn to Stop Worrying About Rates and Love the Fed

(Bloomberg) — If you’re concerned that the Federal Reserve will derail the bond market when it finally starts raising interest rates, the last two tightening cycles suggest those worries may be overblown.

Instead of tumbling, U.S. debt securities from Treasuries to junk bonds gained. They returned an average 5.7% between June 2004 and June 2006, when the Fed lifted rates to 5.25% from 1%. In the seven months ended January 2000, bonds retained their value even as benchmark borrowing costs increased 1.75 percentage points.

With the U.S. economy expanding at a slower pace and less wage growth to pressure inflation, there are fewer reasons for the Fed to raise rates as quickly this time as the central bank moves to end six years of unprecedented stimulus. Long-term bond yields that offer a greater cushion against higher rates than in previous cycles and demand for fixed income from a burgeoning number of retirees also suggest the inevitable selloff forecasters have predicted is less likely to materialize.

“It would be a mistake to bet against the bond market,” Priscilla Hancock, global fixed-income strategist at JPMorgan Asset Management, which handles $1.5 trillion, said by telephone on July 14. “The road to higher rates will be a long, slow march at a time when income is the most important thing. That means fixed income will still be an important place to be.”

MARKET TIMING

In the U.S., debt securities of all types have rallied this year, confounding forecasters’ projections for losses, index data compiled by Bank of America Merrill Lynch show. Their 4.14% average return is the biggest since 2010.

Yields on 10-year Treasuries, the benchmark for securities as varied as mortgages, corporate bonds and emerging-market sovereign debt, have fallen more than a half-percentage point to 2.48% at 7:45 a.m. in New York.

The debate over the Fed’s interest-rate policy and its effect on bonds has been intensifying as the central bank moves closer to ending its monthly debt purchases, which has helped inundate the U.S. economy with more than $3 trillion of cheap cash since 2008 and propped up asset prices.

The stakes have never been higher. In just six years, the global market for bonds has ballooned more than 40% to a record $100 trillion, according to estimates from the Bank for International Settlements.

There’s now a 60% chance the Fed, which has held borrowing costs close to zero since 2008 to restore an economy crippled by its worst crisis since the Great Depression, will start raising rates by July 2015, futures contracts show.

HISTORY LESSON

Last month, the Fed itself predicted the target rate will rise to 1.13% at the end of next year and 2.5% a year later, according to the median projection of 16 policy makers. Based on their long-term growth outlook, they anticipate stopping once rates reach about 3.75%.

That indicates borrowing costs will increase less than in the previous cycle, when they climbed 4.25 percentage points, and rise at a slower pace than in 1999-2000, when rates ended at 6.75%, data compiled by Bloomberg show.

One reason is because the five-year-long expansion is still showing signs of weakness. Last quarter, the world’s largest economy contracted 2.9%, the deepest drop-off since the 2009 recession. Economists say growth will accelerate 3% next year when the Fed starts raising rates. That would still be slower than the 3.8% expansion in 2004 and fall short of the more than 4% pace in 1999 and 2000.

PARADIGM SHIFT

Along with fewer rate increases, investors also have an advantage in higher relative yields as a buffer when the Fed does decide to lift borrowing costs.

Treasuries due 30 years offer 1.61 percentage points more in yield than five-year notes, data compiled by Bloomberg show.

That’s more than the average 1.01 percentage-point gap in the year before every tightening cycle since 1980. The cushion is similar to the one investors had before the Fed started raising rates in 2004, which helped support bond returns.

“An increase in rates doesn’t have to mean rising yields,” Guy Lebas, the Philadelphia-based chief fixed-income strategist at Janney Montgomery Scott, which manages $61 billion, said by telephone on July 20. “The actual event of a rate increase is far less important than it has been.”

For the bond bears, historically low yields mean the margin of error is much smaller and makes 1994 a more accurate picture of the risks investors face when the Fed boosts rates.

INHERENT RISK

That year, the Bank of America Merrill Lynch U.S. Broad Market Index of bonds fell 2.75% in its worst-ever loss, when then-Fed Chairman Alan Greenspan surprised investors by doubling its benchmark rate to 6%.

Based on the index, U.S. bonds now yield 2.21%, less than half the average of 4.84%. A gauge known as duration, which calculates how much prices change when yields rise or fall, has climbed to 5.64, within 0.1 of a record.

“Yields don’t have to rise that much to redistribute significant losses to bondholders,” Christopher Sullivan, who oversees $2.3 billion as chief investment officer at United Nations Federal Credit Union, said by telephone from New York on July 14. “The risks inherent in bonds are certainly higher.”

Economists predict bond yields will increase as the Fed raises rates, with the 10-year note rising more than a%age point to 3.63% by the end of 2015, data compiled by Bloomberg show. Stephen Stanley, the Stamford, Connecticut-based chief economist at Pierpont Securities and a former economist at the Richmond Fed, forecasts yields will reach 4.4%, the highest among the 60 estimates.

GREENSPAN'S 'CONUNDRUM'

Because inflationary threats have diminished over the past three decades, it’s unlikely the Fed will trigger any sharp selloff, said Paul Zemsky, head of multi-asset strategies at Voya Investment Management, which oversees $213 billion.

Starting in 1982, the average rate of inflation has fallen with every expansion, from 3.7% in the eight years ended 1990 to 2.6% in the 2001-2007 period.

Since 2009, consumer prices have increased less than 2% on average and bond traders anticipate about the same rate of cost-of-living increases over the next five years.

“The Fed has won the war on inflation,” Zemsky said by telephone on July 17.

At the same time, the Fed’s preferred measure of inflation has fallen short of its 2% goal for 25 straight months as stagnant wage growth hampers consumer spending.

Reduced inflation risk helps explain why instead of rising, long-term yields fell the last time the Fed increased rates, leading Greenspan point out the “conundrum” in February 2005.

FED'S INTENT

In the month before the Fed started boosting borrowing costs in 2004, bonds fell before rebounding as Greenspan signaled the bank’s intentions.

The push to make the Fed more transparent, which began in earnest under Greenspan’s successor Ben S. Bernanke, also limits the likelihood current Chair Janet Yellen will whipsaw investors as she curtails the Fed’s extraordinary measures.

In addition to releasing projections for rates and growth, the Fed now also targets inflation and gives news conferences after its meetings. Before 1994, the Fed didn’t publicly disclose when it changed policy and Greenspan’s public comments on rates during his 18 1/2-year tenure were famous for being inscrutable or difficult to understand.

Last week, Yellen told lawmakers the Fed must press on with stimulus as “significant slack” remains in labor markets and rates will likely stay low for a “considerable period.”

'MORE TRANSPARENT'

“The Fed approach is much more transparent,” which reduces uncertainty and risk, said Kathy Jones, a fixed-income strategist at Charles Schwab in New York.

A growing number of retirees and pensions are also buying bonds for steady, low-risk income in a demographic shift that’s set to underpin debt demand for years to come. The number of Americans 65 years old or more will increase 14.5 million this decade, the biggest jump versus the total population going back to 1900, data compiled by the Census Bureau show.

“There is tremendous demand for fixed income,” Ed Keon, who helps oversee more than $100 billion at Prudential Financial’s Quantitative Management Associates, said by phone. “And that doesn’t seem to be changing anytime soon.”

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