Everyone seems concerned about when the Federal Reserve will "raise rates," and what that will mean for the stock and bond markets. However, determining what the markets will do seems to be skipping a step. How about first figuring out what impact a Fed rate hike will have on interest rates?
This may seem a ridiculous and rhetorical question, given that the Fed will be raising rates, but keep in mind that with QE over, the central bank has little control over what happens to the long end of the curve. What the Fed will be raising, when they do finally "raise rates," will be the federal funds rate -- the overnight rate at which banks lend money to each other. This rate has been zero (0-0.25%) for over six years.
Janet Yellen and company ended quantitative easing almost eight months ago in October 2014, meaning, the Fed stopped altogether its purchase of Treasury bonds and mortgage-backed securities. And what was the market's immediate response?
Yields on long-dated Treasury bonds (as represented above by the 30-year Treasury) sunk by nearly a full percent in the four months following the culmination of QE. Seems remarkably counterintuitive.
So what happened?
I don't think the answer has anything to do with the rates being paid on that paper. Rather, it has to do with what happened to the U.S. dollar as a result of the Fed's guidance. Removal of QE and the coincident interpretation of fewer dollars in circulation, coupled with the Fed's signal of U.S. economic strength, resulted in a strengthening dollar.
To reiterate an argument we made in our "Themes to Watch in 2015" piece, a strong or strengthening dollar makes U.S. Treasury bonds a perfect hedge for foreign buyers concerned about their own currencies weakening. And the Fed raising short-term rates will only serve to further strengthen the USD against the currencies of foreign countries (where they are still in the process of easing). Our yield curve ought to flatten.
So why would I want to expose myself to the interest rate risk inherent with a 30-year Treasury bond instead of buying the 10-year? That likely depends on how long I want to hedge my currency risk.
Remember, if my currency is losing value against the USD -- say 10% annually (conservative for just about any country in Latin America or Asia) -- a portfolio of U.S. Treasury bonds is an excellent investment, if not just a hedge against inflation. If my currency is losing 20% annually against the dollar, it's a no brainer to load up.
Let's take a look at the recent rate spike on a longer-term scale -- a spike that I contend was not necessarily in anticipation of a Fed move, but profit-taking among bond investors (both of the domestic and international variety) followed by short covering, all the way up to a strong resistance level for the 10-year Treasury.
Something to pay attention to is how various assets have responded to the recent spike higher in rates. Below you can see that some of the typically most interest-rate-sensitive asset classes -- REITs (Vanguard REIT ETF (VNQ)), master limited partnerships (JPMorgan Alerian MLP ETN (AMJ)), long-dated Treasury bonds (iShares 20+ Year Treasury Bond (TLT)), and utilities (iShares US Utilities (IDU)) -- haven't been nearly as affected as you might think by a 30% spike in rates.
Are the somewhat subdued moves in these asset classes telling us that rates moving appreciably higher from here is unlikely?
In my view, many are misunderstanding the potential impact of the Fed "raising rates." And it's possible, once again, that fears of rising rates are misplaced. The asset classes depicted above are, actually, the place to be right now.
I believe the idea that long-term rates are certainly going to move higher from here is a bogeyman. And positioning one's portfolio out of fear of the bogeyman could be a costly mistake.