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Bond duration backers under pressure as rates rise

Bond duration backers under pressure as rates rise

The US Federal Reserve’s decision on Wednesday to hike the target interest rate by 25 basis points to 1.75% this week was widely anticipated, but what the future holds remains a topic of hot debate.

Stocks initially rallied after the US central bank forecast 0.2% GDP growth and a 0.3% fall in the unemployment rate for 2018. They later fell slightly in reaction to the cautious language used in the statement by the Federal Open Markets Committee in which it said it expected the economy to ‘expand at a moderate pace in the medium term’.

That was closely followed by an outbreak of dissension on the Bank of England’s Monetary Policy Committee on Thursday, with a two-to-seven rebellion calling on an immediate rate hike leaving a Q2 increase in sterling borrowing costs a near certainty.

While the direction of travel is certain, a lot of uncertainty remains about how hard policy makers are pumping the monetary brakes. Benchmark 10-year US Treasury yields climbed last week to retest the February ceiling of 2.9% but credit spreads remain below recent peaks: if inflation is perceived to have spun out of the Fed’s grip there is still potential for things to get unruly this year.    

Citywire A-rated Neil Birrell, chief investment officer and fund manager at Premier, said he was comfortable with the range of the Fed’s current predictions beneath incoming chair Jay Powell.

He added that there was no discernible break from predecessor Janet Yellen and Powell’s comments were ‘consistent with previous guidance’. But even so, he added that underlying nervousness about a potential inflationary surprise should not be discounted.

‘In the very short term, this will probably have little impact on bonds equities or the dollar. But there is still the risk that if the economy continues on this path, that rates may need to rise sooner which would put bonds and probably equities at risk and benefit the dollar,’ he said.

AXA Investment Management senior economist David Page said he believed the fed was falling behind the curve however, and was likely to significantly toughen its stance as the year goes on. He expects a further three rate hikes this year, rather than the officially-predicted two. 

‘We note that the range of the central tendency associated with the outlook for 2020 increased by 50bps to 3.1%-3.6% (from 2.6%-3.1%), suggesting Fed participants basically assume another two hikes in its profile compared to December’s forecast.

‘Powell’s insistence that the focus on the dots was not as important as the next decision was, we suspect, a suggestion that he considers four hikes more likely.’

BlackRock head of bonds Rick Rieder said that far too much attention was currently being paid to the incline of the short-term yield curve, however. A sharp inversion in long-term rates over the second half of last year suggested the weight of money was making very different assumptions about the future potential of the global economy than the Fed, he said.

Bridging the difference between the Fed’s assumed reversion to a long-term mean and the downbeat assumptions seemingly priced into bond yields may involve a sharp and violent revision on one side of the equation, he said.

‘There is dramatically more information value to be had from the Fed’s prognosis of the current economic situation … than anything significantly longer than that.’

‘From an investment standpoint, we think that this Fed will not be excessively focused on the speed of normalization, but rather will place an emphasis on its duration.

'Thus, we think that investing in shorter-term interest rates provides a much greater degree of certainty and lower volatility. Longer duration [interest-rate sensitive] assets need to be handled with care, as only small rate moves can exhibit large hits to principal in these parts of the markets.’

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Neil Birrell
Neil Birrell
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