No amount of reassuring rhetoric by Janet Yellen and her colleagues at the Federal Reserve can prevent markets’ overreaction when benchmark interest rates start heading higher.
That’s the conclusion of Deutsche Bank AG economists Joseph LaVorgna and Brett Ryan after studying turns in Fed policy in the past two decades.
Take 1994, the annus horribilis for bond traders. The selloff of the 10-year note sent its yield up 203 basis points as the Fed raised its benchmark by 250 basis points, according to Bloomberg data.
In 1999, the Fed began boosting rates in June, extending a decline that left the yield up 179 basis points in the year. By 2003, disappointment the Fed didn’t cut more deeply was reflected in a rise in yields of 43 basis points over the year with a surge of more than a percentage point in the third quarter.
Even a rate cut in January 1996 was followed by a rise in 10-year rates of 85 basis points over the course of the year as signs of economic strength led investors to rein in forecasts of more reductions.
That takes us to 2013, when a signal that the Fed would soon start winding down bond purchases generated the “taper tantrum.” The yield ended the year 127 basis points higher than where it began.
‘Swift and Violent’
So take the five tantrum years together and the average yield spike is 137 basis points. That’s a third higher than the 100 basis points the International Monetary Fund said last week was possible and warned even “shifts of this magnitude can generate negative shocks globally.”
“If history is a guide, a backup in Treasury yields could be both swift and violent, with most of the move occurring over a short period of time, generally within two months,” said LaVorgna and Ryan. “If anything, the IMF’s warnings might be too conservative.”
Now there’s always 2004. That’s when the Fed began its last cycle of rate increases, yet the 10-year yield was flat over the course of the year. Still, that may be down to the Fed’s pledge to act “at a pace that is likely to be measured.” Officials now say they won’t mimic that approach.
All the more reason to worry is that markets are low on liquidity and that investors don’t seem to be on the same hymn sheet as the Fed. According to the so-called dot plot, the median projection among Fed officials is that the federal funds rate will be 1.875 percent by the end of 2016.
“If the Fed raises rates later this year, and it causes a re-evaluation of the projected path of monetary policy, then history could repeat with the 10-year Treasury yield shooting substantially higher,” said LaVorgna and Ryan. “Monetary policy makers have told us that they anticipate a gradual normalization of interest rates, but the reality is that they do not know.”