The Fed Won't Ruin Bond Markets
With the Federal Reserve poised to unleash its first interest rate increase in almost a decade there's a debate among investors about whether the past is any guide to how markets will react to a monetary tightening. The to-and-fro brings to mind automobile entrepreneur Henry Ford's famous insistence that "history is more or less bunk." But traders might be better served to recall a quote attributed to Mark Twain -- that even if history doesn't repeat itself, it does rhyme.
The naysayers argue that the current environment is without precedent. For example, Gary Jenkins, a strategist at London-based fund manager L&G Capital, wrote this week about an imaginary investment banker whose career started in 2006 and who reaches for her textbooks to understand what a Fed rate rise might mean. "Experience does not really give her any major insight into what will happen from this starting point," Jenkins wrote. "More worryingly, nor does anybody else’s."
Quantitative easing has seen the Fed's balance sheet more than quadruple in the past seven years to $4.5 trillion; the bond-buying program also means Treasury yields have been driven to record lows. Moreover, with the Fed Funds Target Rate stuck at 0.25 percent since the end of 2008, the market is full of fresh-faced traders with zero experience of buying and selling securities when rates were anywhere other than close to zero.
Who knows how they'll react to a policy move? Maybe they'll panic and start selling everything in sight, making the 2013 taper tantrum -- when Treasuries lost $1.5 trillion of value in a fortnight at the merest hint the Fed would scale back QE -- look like a walk in the park.
Or maybe not. It's worth consulting the history of bond market reactions to Fed rate increases in the past 15 years or so. The record suggests there's nothing much to fear from a change in direction by the central bank.
There have been four Fed tightenings in the past decade and a half, as illustrated here:
That 1994 interest-rate move produced a classic bond market reaction. Both two-year and 10-year Treasury yields rose, proving that if the central bank wants higher borrowing costs to dampen growth and stifle inflation, it typically gets its way. And the shorter-maturity interest rate rose faster the following year, which in turn produced what's called a flattening in the yield curve. The narrower the gap between two- and 10-year rates, the flatter the curve is said to be:
The 1997 tightening might -- might -- turn out to be the most instructive historical example. The Fed raised its benchmark rate by a quarter-point to 5.5 percent in March of that year, and then held it there for the next 18 months. There are plenty of economists who expect the Fed's coming rate hike to be a "one and done" maneuver in the same vein. The suggestion is that policy makers are uncomfortable with rates so close to zero for so long, but the growth and inflation outlooks don't warrant a series of rate hikes; a single move would exorcise the Fed's philosophical demons, followed by a pause while the economy stays in rehab.
What does 1997 teach us to expect from such a move? As the following chart shows, the yield curve flattened in the year after the rate hike, but both 10- and two-year yields declined, signaling that a single move isn't enough to spook bondholders into driving yields higher. Depending how the Fed tempers this year's message, that could prove prescient:
Skipping forward, the 1999 tightening cycle produced a more extreme bond market reaction. Two-year yields didn't just rise faster than 10-year levels, they outstripped their counterparts to produce what's called an inverted yield curve, where short-term borrowing costs are higher than those for a decade. But, even then, the climb in yields was slow and steady, rather than dramatic and wrenching:
And the last time the Fed raised rates, all the way back in 2004, the yield curve delivered a textbook reaction -- albeit with a twist. Two-year yields did what they always seem to do, climbing higher; but 10-year borrowing costs marched lower at almost the same pace:
The Fed is fully aware of the risk that a rate increase will send the bond market into meltdown no matter how loudly it telegraphs its intentions. But with due respect to George Bernard Shaw's warning that "we learn from history that we learn nothing from history," there's nothing in the archives that suggests investors will run screaming for the sidelines just because the Fed starts tweaking borrowing costs.
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