Last week, the Federal Reserve released its "Dot Plot", which is a plot of what each member of the FOMC thinks the Fed Funds interest rate will be. They think they will have raised interest rates 3.75% by the end of 2017. That's a lot, and it has big implications for bond funds. The big question: if they raise rates 3.75%, how much will the 10-year Treasury yield rise? Will it also go up 3.75% from where it is now, which is 2.57%? IF it does (admittedly a very big IF), we are going to see some big drops in the NAV of bond funds. Take the Total Bond Market Index Fund (VBMFX). It has a Duration of 5.7 years. For every 1% increase in the corresponding interest rates of the bonds in the fund, the NAV is expected to drop 5.7%. IF the yield on the bonds in the fund goes up 3.75% over 3 years, we could see a 3.75 x 5.7 = 21.4% drop in the price of the fund. Add in the yield to get the total return. The current SEC yield is 1.99%. With a rise in rates/bond yields, the bond fund SEC yield will rise, but since the average bond in the Total Bond Market Fund has a maturity of 7.8 years, it should take a long time to clear those bonds out of the fund for the yield to rise enough to significantly offset the NAV drop. Not a pretty scenario for the bond market.
Your comments please!
http://blogs.marketwatch.com/capitolreport/2014/09/17/dot-plot-shows-fed-will-be-quick-about-raising-rates-once-it-starts/?mod=MW_story_top_stories
Comments
The end of 2017 is a long ways off. The economy needs coddling beyond the current administration. Steady as she goes.
There seem to be two big IFs:
1. Will the Federal Reserve actually raise rates 3.75% by the end of 2017?
2. What will happen to longer term interest rates, such as the 10-year Treasury rate?
PIMCO doesn't believe the Fed will go that high. Bill Gross and company believe there will be a "New Neutral" rate of 2%, not the old standard of close to 4%, which apparently the Fed still believes in.
But look, the Fed just said last week that this is what they expect to do! And they told the whole world. We'll see who turns out to be correct, the Fed or PIMCO.
With regards to your question about "will bond funds perform better than equity funds in this same climate", I have no idea. I've read that stocks have not reacted nearly as badly as bonds to the initial volley of interest rate hikes. But who knows if the past historical patterns will repeat themselves.
I felt that under Bernanke they were very attuned to the markets - especially commodities. Generally when commodities slid, they found a way to bolster the markets with dovish (and seemingly well orchestrated) statements from different governors. That's not happening this time.
Haven't paid due attention to PIMCO. But keep in mind the increases in the overnight lending rate, which I think they're talking about, could very well tank the equity markets and push money into longer bonds - which would cause long term rates to fall. Not sure there's any inconsistency in the two predictions.
A little more .... rjb112 Your math sounds correct. If and when longer rates rise longer dated bonds will get killed. The math is awful. My point above is that raising the short term lending rate doesn't necessarily have to cause longer rates to rise. Under some scenarios, depending on economic conditions, it could conceivably cause longer rates to fall. Seems to me some bond fund managers are betting on that second possibility occurring.
JSHT
"the Fed just said last week that this is what they expect to do! "
And how many times has one Fed governor said one thing only to have another Fed governor say the opposite a few days later? How many times have they changed their forecasts? How many times have they moved the goalposts?
Go about your business and invest in a way that is appropriate for you. This whole situation with what the Fed is doing and analyzing whether or not a couple of words ("considerable time") were the same on the last Fed statement has really brought this whole thing into a new realm of utter ridiculousness. (Yellen: "No mechanical interpretation of "considerable time" - in other words "it depends on what your definition of is is".)
Edited to add, and sure enough...."http://headlines.ransquawk.com/headlines/fed-s-kocherlakota-says-should-be-very-cautious-about-starting-to-raise-rates-with-inflation-so-low-23-09-2014"
Absolutely agree. Fed-speak makes interesting conversation. That's all. Stick to your long range plan whatever it is and ignore the noise.
In terms of what happens when the Fed raises rates, in theory at least, the longer the term the less the rate should adjust. That's because what people believe about the next 10 years shouldn't have a 1:1 relationship with what happens today (although admittedly it does sometimes) and because future rates should already discount what's expected for the future.
I think if you wanted you could use the historical information from the Fed to graph or create a table of what has historically happened to 10 Years when the Fed Funds rate changes, or pretty much any other comparison you'd want to do.
federalreserve.gov/releases/h15/data.htm
If you do that I'm sure lots of people, including myself would love to see the graph
The following link shows the history for the Fed's target for rates. To my surprise when rates have gone up historically they've gone up pretty quickly.
newyorkfed.org/markets/statistics/dlyrates/fedrate.html
Lets say they start raising in June 2015. That would mean 2.5 years to run it up to 3.75. The economy would have to be doing very well for that to happen.
Personally, I have no forecast for interest rates, the bond market or the stock market. I'll leave the forecasting to others.
The historical Fed Funds rate was very interesting. Last month is shows the Fed Funds rate was 0.09%. In June 1981 it was 19.1%. That gives plenty of information for interest rate and bond market forecasters to work on.
You're right, it would be very instructive to compare changes in the Fed Funds rate with what happened to the 10-year bond. Or just a comparison between the Fed Funds rate and the 10-year Treasury. Hmmm....maybe Charles would love to sink his teeth into that data.
This is the best thing I have heard in a while.
1. Of course, Fed dialogue and actions have an effect on my investments.
That said:
2. You have a market where people are making their choices (not saying that people here are, just sayin') increasingly based upon what the next words out of Yellen's mouth may be and I think that's the continuation of a market that is reliant to a concerning degree upon not only Fed action, but even the slightest of Fed discussion. The level of Fed speculation (the whole thing recently about whether "considerable time" would be changed or not) has gotten ridiculous. The view that bad news is good news because that means the Fed will be easier longer is dismaying for a number of reasons, a big one because it's focusing on the ultra short-term in an economy that I think desperately needs to plan a route for a sustainable long-term.
3. If you are all Asia because that's what you believe in, own it and accept the potential volatility and potential under/outperformance if something effects that region. If you are all income of various shapes and sizes because maybe you feel like its appropriate for your age or compound interest is one of the few things closest to an investment guarantee, own it. Know that Fed action will have a significant effect on your holdings, but believe that those in charge of your holdings are actively trying to prepare for the eventuality - and as some people (Heebner of CGM Focus, for example) have found out, the "inevitable eventuality" is not happening nearly as quickly as they thought it would. Have the longer term view and continue to reinvest in income holdings if you get lower levels.
Own your best ideas, whatever or whereever they may be. You don't have to own them for decades, but I do think Buffett's "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years" is a good question to help filter out things you are trying to decide whether or not to invest in.
So yes, what Yellen says and does has an effect. If you are making decisions based upon what Yellen may say next, I just think that's only going to result in unnecessary stress and problems.
In Fed terminology, I think that's called "acclimating" investors. But, I'd rather try to guess the weather in "Fuji-Fuji" tomorrow than to predict what they will really do next.
Is Ted missing lately? Hope all's well with him.
Take care.
Super strong bidding today for 2 year notes at 0.589%, primarily from foreign central banks.
Folks, that's before your short term bond fund takes its cut (the ER). So, that "safe" investment's going to earn you essentially nothing. OK - Should Armageddon occur within 2 years, prices might spike higher.
Edited to add:
The Chicago Fed's Charles Evans doesn't disappoint his dovish fans urging the FOMC to "err on the side of patience in removing highly accommodative monetary policy," and not to worry about an inflation rate moderately exceeding the 2% target for a limited time."I am very uncomfortable with calls to raise our policy rate sooner than later. I favor delaying liftoff until I am more certain that we have sufficient momentum in place toward our policy goals."
lol.
http://seekingalpha.com/news/1999685-evans-fed-needs-to-be-extraordinarily-patient-on-rate-hikes
They have their "new neutral" at 2%.
Of course, the FOMC members do think the neutral policy rate will be at 3.75%, according to their "dot plot"
We shall see.