This week Federal Reserve Chair Janet Yellen provided routine testimony during an FOMC meeting. Transcripts of the minutes from these regular meetings are parsed the world over, in a vain attempt to read the tea leaves and interpret the Fed’s next move when it comes to raising the federal funds rate – a key monetary policy tool to either contract or expand money supply in the US economy. After years of near zero fed funds rates, markets are nervous about how quickly the tightening cycle will be. From my perspective, it’s going to be much more tightening, much sooner than many are thinking.
With this latest FOMC meeting, the target range for the fed funds rate (overnight uncollateralized borrowing rate between banks) remains at 0.50 – 0.75%. It’s important to note that the Fed navigates a range and does prescribe or enforce a specific percentage. The effective federal funds rate is more representative of the true rate, which has been 0.66% most recently. The target range provides flexibility within the system, since market participants have rate expectations that are a volatile factor in our money markets.
In the chart above, rates on the 10 Year US Treasury, high grade corporates, and the effective fed funds rate are shown on a percentage change basis from one year ago. One of the reasons I love graphs is that they do sometimes illustrate quirky workings of the capital markets. In the circled area, you’ll see that both treasury and corporate rates jumped in early November 2016, which coincided with an unexpected Trump victory. Weeks later, Yellen confirmed what markets had already priced in. Fed action only came after markets had decided the trajectory of interest rates and inflation expectations.
In the year ahead, the Fed is expected to raise rates 0.25% three times. Given recent history, this would mean bond markets will find their yields jumping higher fueled by growth and inflation expectations. But, rate hikes would only be adjusting money supply in a marketplace that has already assumed these rising levels, and then some. Year-end levels on the 10 Year US Treasury could be extrapolated using the recent market front-running on FOMC announcements. In last December’s 0.25% move, there was a 0.75% move in treasury rates. If this relationship continued, the 10 Year Treasury would end the year around 4.75%. That is some serious movement, and is definitely not happening. But with a 30% discount due to a diminishing inflationary sentiment with future rate increases, it could very well end up around 3.32%. Hold onto your hats! Shorten your bond maturities and durations. We could be in for some big yield jumps this year.