3 Fed Scenarios For Bond ETF Investors

August 19, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Bob Leggett, senior portfolio advisor at Akron, Ohio-based ValMark Securities, which markets the "TOPS" brand of asset allocation models.

Fall is right around the corner. Does it seem as if the speculation about Fed funds rate increases has been going on for a really long time?

Discussion of the reversal of the Fed’s Great Recession rate cuts (from 5.25 percent in June 2007 to near zero in December 2008) began in 2010 and has continued off and on ever since. Over the past several months, expectations for the first Fed funds increase have centered on September, and here we are in August. So, we can no longer brush it off as an event of the distant future.

Three Possible Scenarios
As we anticipate turning to the next calendar page, most portfolio managers are weighing the potential effects of Fed actions on their portfolio strategies. Worries about tightening are rational, because Fed funds rate hikes have historically negatively impacted financial markets. However, the impact of the actual announcement differs under different circumstances.

While there are many ways that this may play out, three popular scenarios include:

  1. Well-anticipated Fed funds increases versus surprises
  2. Steepening yield curve due to “too hot” fears
  3. Flattening yield curve due to “too cold” worries

Before discussing the scenarios, we’ll set the stage for how we arrived at this point.

Since the Fed finished cutting rates back in 2008, we experienced:

  • The invention and implementation of quantitative easing bond purchases by the Fed that increased its balance sheet from $900 billion to $4.5 trillion
  • The bond market “taper tantrum” of 2013, and the eventual tapering and end of QE. Throughout that period, the Fed funds rate was unchanged at 0 to 0.25 percent, a policy referred to as zero interest rate policy (ZIRP)

The QE demand for bonds, combined with low inflation, drove longer-term interest rates down, plunging the U.S. Treasury 10-year bond yield to 1.4 percent in July 2012.

When then-Fed Chairman Ben Bernanke suggested in May 2013 that QE might be reduced (tapered), a taper tantrum ensued that popped the 10-year yields from 1.9 percent to 2.8 percent in three months. However, expectations of normalization were denied, as rates steadily declined into early 2015, and that 10-year yield has traded in a fairly narrow 1.9 percent to 2.4 percent range for the past six months.

The unprecedented Fed policies have made life difficult for investment strategists, but the end of QE’s bond yield suppression and the impending end of ZIRP may allow investors to use historic comparisons fairly soon.

As we explore how the shift toward “normal” Fed policy impacts the markets, we will limit our discussion to fixed-income strategies. However, we plan to address equities in a future piece.

Well-Anticipated Fed Hikes

If investors anticipate the Fed’s actions, the markets may discount the move before it takes place. Further, if the Fed takes a slow and steady path versus rapid increases or stops and starts, the bond market may react fairly calmly, with the yield curve shifting higher in parallel.

In this circumstance, the economy, employment and wages would continue growing at or just below long-term trends, and inflation would remain well-contained. This seems to reflect the current environment and could mean the Fed increases rates at a slow, steady 0.25 percent pace.

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