The post below is taken from our Sept 14, 2014 interest rate and Fed Funds rate increase historical perspective piece.  Given the current debate on the timing of a rate increase, we believe it would be helpful to take a look again at some historical evidence.

At this point, we view rate volatility to remain the risk as opposed to a major regime change where rates find a new much higher equilibrium. Over the next few months, we advise that your firm take advantage of volatility to add to high quality duration. Below is the past article.

Rate fears, rate reality and some history.   There is a lot of concern with regard to interest rates and the inevitable higher levels in most investors minds. We feel it is worthwhile to examine history with regard to interest rate increases and the effect on the overall yield curve or long rates specifically.   Short term and long term rates react differently to market dynamics and the “rates will rise” concern, while very legitimate needs to be dissected and assessed in a historical context. This will help advisors and investment committees sort through and adjust their portfolios given some potential scenarios.   According to a June 2014 Economics report by Credit Suisse, there have been four Federal Reserve tightening “cycles” of various sizes and durations over the past two decades.   (First Rate hike)                      Full Cycle

Starting Fed Funds Target Date Size basis pts Length in months Size in basis points Number of rate hikes Terminal Fund rate
3 Feb 94 25 13 300 7 6
5.25 March 97 25 1 25 1 5.5
4.75 June 99 25 12 175 6 6.5
1 June 04 25 25 425 17 5.25

*Source Credit Suisse from the Federal Reserve   “Fed tightening cycles were initiated at different times of various business cycles, against different economic and financial backdrops. But there are a few overarching themes common to all these episodes. 1. In general, the FOMC recognized the importance of fighting inflation before inflation was a problem. A long-term chart of inflation overlaid with initial Fed rate hikes suggests that the Fed had success in this endeavor. The challenge then, as now, was to balance the benefits of pre-emption with the costs of potentially tightening prematurely. 2. Each of the past four rate hike cycles began with a small, 25bp rate hike. Many of these cycles began after years without a tightening, and the FOMC assumed that the first rate hike after a long hiatus would have an over exaggerated effect. 3. In tightening cycles over the past 20 years, the FOMC took seriously its obligation to explain to the public why rate hikes were necessary, and the Committee took various steps to prepare the markets for tighter credit conditions.” *Source credit Suisse   It may be helpful to note that 10 yr rates rose prior to the initial tightening in 2004 and subsequently declined after the tightening. This may help as the thought that rates will “explode” upward at all points on the yield curve may be slightly misguided if history parallels. In part the decline is or may be due to the perception that the Fed has inflation under control. It may be once again that the market on the long end of the curve moves higher in yield in order to encourage the Fed to begin to raise rates to stave off potential inflation and to begin to drain the massive amount of excess liquidity from the system.   Charles Schwab’s Fixed Income Team recently compiled a piece with regard to this issue and feels that given Fed statements with regard to timing, we are looking at mid 2015 as the first of the Fed Funds Rate Hikes. Here are a couple key points.

    • Improving economic data hasn’t changed our estimate that the first Federal Reserve interest rate hike of this business cycle will occur in mid-2015.
    • As the Fed raises rates, we think the yield curve will flatten as yields increase on the short end of the curve.

That implies that investors should not completely abandon all duration as they seem to believe that longer term rates are reasonably anchored. We at Zenith also believe that longer rates may rise but not substantially and though there may be a bond bubble, it is not imminently going to burst. They cite some important statistics. “The economic data have not been consistently strong and inflation is holding near 2%. For example, much of the increase in the Q2 GDP estimate was due to a rise in inventories, which may suggest slower production as those inventories are drawn down. Also, housing activity has slowed substantially this year. Moreover, the majority of Fed officials are focused on unemployment. One measure they’re watching is the high level of “underemployment,” which includes those who are working part-time because they can’t find a full-time job, as well as those who are marginally attached to the workforce. Additionally, the number of people unemployed for over six months remains above 30%—high by historical standards.” They cite the important short-term/long-term rate dynamic similar to the work Credit Suisse provided on the subject. “We expect the yield curve to flatten as the first Fed rate increase of the cycle approaches, meaning that short-term yields will rise more than long-term yields. This was the pattern in the past three Fed rate hike cycles–in 1993-94, 1998-2000 and 2003-06. In each case, more than half of the increase in 10-year Treasury yields from the cycle trough to peak occurred before the first Fed rate hike, and then yields on the short end of the curve began to follow suit. It seems likely to us that if the Fed begins to raise short-term rates next year as indicated, a similar pattern will unfold, for three reasons. First, short-term interest rates are still near zero, where they have been for nearly five years. Meanwhile, long-term rates have already risen by nearly 100 basis points from the lows of last year. A basis point is one-hundredth of a percentage point. And with inflation at 2%, short-term rates are negative in real terms, while real long-term rates are at least positive. It appears to us that the process of “normalizing” interest rates has already begun for longer-term rates but not for short-term rates. Second, inflation and inflation expectations are relatively stable. While short-term interest rates are heavily influenced by Fed policy, long-term rates are influenced to a great extent by inflation expectations. Currently the indicators for inflation expectations that we follow, such as the implied inflation expectations in the TIPS market, suggest that expectations remain steady near 2%. Third, the yield curve is already quite steep by historical standards. Although the yield curve has flattened since the start of the year as long-term rates have fallen while short-to-intermediate term rates for two-year to five-year bonds have risen, the difference is still wide compared to the long-term average. Over the past ten years, the average difference has been 95 basis points. It currently stands at over 200 basis points.” We at Zenith understand the immense challenges for any fixed income investor and stand by ready to help you analyze and determine your current risk profile as a whole and by product. As mentioned in our previous segments to this series, there are overvaluations in the US and globally. We also believe that there are managers who are able to potentially mitigate some of this risk and also who may be able to uncover value. We hope you enjoyed this short piece on the rising rate question and welcome your thoughts, concerns or observations you have with regard to this issue. We will be back next week with some manager selection and insight for your consideration. Sincerely, Tom Koehler-CIO

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