|by Adam Shell, USA TODAY|
The Federal Reserve will start hiking short-term interest rates in 2015, but the transition to higher borrowing costs won't lead to massive turbulence in the bond market or cause yields on longer-term bonds to skyrocket as many on
One of the big financial stories in 2015 will be the start of the Fed's move to normalize historically low rates and continue to pare back stimulus. The U.S. central bank, led by chair
(On Wednesday, USA TODAY rolls out the third installment of its "Investment Roundtable" coverage with insights on the big-picture outlook for the U.S. stock market in 2015 from
Unlike some doomsayers, Rieder, one of four top
For one, he downplayed a bursting of what many pundits say is a bubble in the bond market.
"The bond bubble story started about five years ago," Rieder says. "But the reason why bubbles burst is you have too much supply relative to demand. But today in the interest rate and fixed-income world you have a dynamic where you have too much demand relative to supply. And that is the inverse of what a bubble is."
The reason: In today's world most countries are deleveraging, or paying down debt or borrowing less. That translates to less leverage in the system."So what happens," Rieder says, "is you don't produce enough fixed income assets."
* What's the call?
"I think the concept, that when the Fed starts moving that it is going to be a problem for markets, is dramatically overblown," says Rieder, who manages three bond funds for
Investors, he argues, have to put the Fed's coming policy change into perspective. One thing to remember is that the coming rate-hike cycle is starting from a very low base.
"We are at 0% on the Fed funds rate, and a 0% rate suggests emergency conditions," Rieder explains. "But we are far from emergency conditions. U.S. GDP growth the last two quarters has come in at around 4% or higher."
* What will move the market?
When it comes to Fed rate hikes, investors must pay attention to three things: the speed at which they move, the pace of the hikes and the final destination, or how high rates will be when they are done, Rieder says.
On the question of speed, Rieder expects the first rate hike in June but adds that the "window is open for them to move faster than that." But the total hike next year won't be huge, he stresses.
"When they move they will move to a 1% Fed funds rate, which on a historic basis is an incredibly low and incredibly accommodating policy."
When it comes to the pace of the hikes, Rieder thinks the Fed will keep rates "under 2% for a long time – for at least a number of years."
Most important, Rieder thinks that due to slower economic growth in the U.S. than in the past and slower growth abroad, the Fed will keep the Fed funds rate at a lower level for a longer period of time than it has historically.
So, while short rates, or bonds that mature in three or five years will move up more "significantly," long-term interest rates – which the economy is more sensitive to – "should stay very well contained," Rieder predicts.
He says fair value on the 10-year Treasury note is 2.75% to 2.80%, or roughly half of a percentage point from Monday's closing yield of 2.26%. A move up to fair value next year is likely, he adds. But with 10-year Japanese government bonds yielding less than 0.50% and German 10-year bonds trading at 0.70%, the 10-year Treasury "looks like a steal relative to the other markets," Rieder says.
Rieder says even if the Fed ratchets up short-term rates 0.50% (or 50 basis points) or 0.75% (or 75 basis points), longer-term bonds may only see a bump up in yield of say 0.25% (or 25 basis points).
He cites a few key reasons why long-term interest rates, such as 10-year and 30-year Treasuries, won't shoot up as dramatically as short-term rates in 2015.
For one, he only expects a "moderate move" higher in short-term rates from the Fed.
Another big factor is the need for fixed-income investments – or consistent streams of incomes – is bigger than ever due to demographic shifts related to an aging population.
"You have never seen in history a population globally that is aging like it is today, which means the demand for income is truly epic," says Rieder, adding that insurance companies and pension funds also have a tremendous need for income generated from bonds.
Finally, the fact that many central banks around the world, including the
Says Rieder: "Rates will move up, but it is very hard for rates to move up that much because of this aging population, because of the need for income and because of where the other central banks around the world are moving."
Still, despite his less bearish callr, Rieder won't rule out a tough year for bond investors, nor the possibility of investors suffering negative returns in the bond portion of their portfolios.
Diversification is key, he stresses.
"You can have zero returns or moderately negative returns in a traditional fixed-income portfolio," he says. "That is why we are big believers, that going into 2015, you have to be flexible, you have to be tactical about where you find your interest rate opportunities, and also look to take your interest rate risks in other parts of the world that are not growing as quickly as the U.S. is."
* What's the biggest risk?
With central bankers in the eurozone and
"Monetary policy just buys you time," Rieder says. "If the markets get a sense that it is not working, and it is just buying time and (there are) no fiscal initiatives or no real growth, then all of the markets will start to turn down."
Rieder also warns that investors that are are all crowding into many of the same trades might be at risk.
"Everybody is long the dollar, everybody is short U.S. interest rates and long European front-end interest rates," he says.
To avoid getting hurt in those trades in the event they reverse and the tide quickly moves in the other direction, Rieder says: "You have to diversify like crazy."
* Bonds to watch?
Rieder likes long-dated municipal bonds. Depending on the state one lives in, an investor can get a tax-adjusted yield of 7% to 8%.