Bond yields drifted gently higher this week in response to the Fed’s comments on the improving U.S. economy and its belief that this economy can absorb an increase in short-term rates. The smart money’s on penciling in one more rate hike in December, bringing the short term lending rate from 1.250% up to 1.500%. More importantly, the Fed also discussed its intention to unwind its massive bond portfolio. This wind down will take several years and the Fed has discussed the wind down formula very clearly to the marketplace in order to avoid another “taper-tantrum”. However, the wind down of a portfolio of this size is unprecedented as the Federal Reserve currently holds $4.5 trillion of US and mortgage bonds. While we hope this will go smoothly, one cannot be sure given the massive void in the marketplace the private sector and other Central Banks will need to fill.
There are two reasons that both the equity and bond market have responded favorably to the Fed commentary this week, even in the face of increased interest rates and a less accommodative monetary policy. First, inflation remains low and there is a growing feeling among economists that a 2% inflation-growth rate may be too high. This benefits stocks and bonds greatly. Second, while the Fed is beginning to tighten, central bankers in Europe and Japan continue to buy bonds and other assets. These purchases continue to keep global yields low.
In other news, the U.S. and North Korean tension continues to escalate, but to date the markets have not been adversely affected by this potential scary geopolitical event.
Given the extraordinary technical nature of the large central bank’s unprecedented involvement in the financial markets, we remain biased toward locking-in interest rates especially now that the Fed has confirmed its intentions to move away from extreme monetary policy. While we can make the argument for lower interest rates, we feel it is prudent to remain cautious while interest rates remain so low.