Chandler Bond Market Review

Monetary Policy: Treasury Yield Curves in a Tightening Cycle

The Federal Reserve has been exceptionally vigilant in utilizing all of the tools at their disposal to promote the dual mandate of price stability and full employment in the current easing cycle. Prior to the financial crisis in 2008 the Federal Reserve adjusted monetary policy almost exclusively through the Fed Funds rate. As the economy strengthened and the unemployment rate dropped, the Fed Funds rate would be set at higher intervals to act as a countercyclical force against the economic recovery to contain inflation and promote price stability. The tightening of monetary policy via the Fed Funds rate also fed through to longer maturity assets with yields increasing generally at all maturity points.

The team at Chandler took a look back at three previous tightening cycles to gain a better perspective on what to expect in the next tightening cycle regarding the Fed Funds rate and the Treasury yield curve. Neither Chandler nor the Federal Reserve are forecasting monetary policy to tighten in the traditional sense during fiscal 2013 – the purpose of the article is to get investors thinking about potential implications for their portfolio when the tightening cycle does commence. It is also important to note that due to the extraordinary measures taken by the Federal Reserve away from traditional monetary policy in the current easing cycle, primarily the various forms of Quantitative Easing (QE) and the corresponding expansion of the Fed’s balance sheet, the Federal Reserve will have traditional and non-traditional tools at its disposal to serve as a countercyclical force to the expanding economy. If inflation does surprise to the upside, the Federal Reserve has the ability to sell assets from its balance sheet, in addition to raising interest rates, to aggressively counteract any surge in inflation. Clouding our ability to draw definitive conclusions based on the historical data set is the fact that the Fed Funds target has never been set this low (0.25%), for this long (four plus years), which has over time contributed to the very low current yields on Two-year, Five-year, and Ten-year Treasury notes (see the below table).


In each of these three historical tightening cycles, a positive spread differential existed between the Fed Funds target and the Two-year Treasury prior to the beginning of a tightening in policy. In the May 2004 – June 2006 period the Fed Funds rate started at 1.00% versus Two-year notes at 2.54%, in May 1999 – May 2000 Fed Funds started at 4.75% versus Two-year notes at 5.40%, and in January 1994 – February 1995 Fed Funds started at 3.00% versus Two-year notes at 4.11% (see chart and tables). Also of note, at the beginning of each of the respective tightening cycles the Treasury curve had a positive slope (i.e., longer maturity notes had higher yields than shorter maturity notes). In all three tightening periods, the shorter the maturity of the Treasury notes, the closer the correlation to the change in the Fed Funds rate at the conclusion of the tightening cycle. The orange bar in the graphs highlights the yield change over the period for each of the respective securities. In all cases the longer the maturity, the smaller the overall change in yield (in the first cycle Ten-year notes change by 0.49%, in the second cycle Ten-year notes change by 0.67%, and in the third cycle Ten-year notes change by 1.56%).

Currently, the spread between the Fed Funds rate and the Two-year Treasury note is close to zero (0.25% versus 0.24%), implying in the next tightening cycle the Two-year note may match the change in the Fed Funds rate based on current valuations in a best case scenario. In longer maturity points, we can conclude the move wider in yields versus the Fed Funds rate will be less than one times the Fed Funds rate change, but clearly the starting point in yields at the beginning of the tightening cycle is crucial. The current low level of yields on both Five- and Ten-year Treasury notes supports the earlier notion that a tightening of policy is not priced into the market for 2013. We would anticipate longer maturity yields moving higher before the Fed begins raising the Fed Funds rate, thus the Treasury curve is likely to become steeper (differential between Ten-year and Two-year Treasury notes expands) before the commencement of a change in the Fed Funds rate.

The Federal Reserve publishes forecasts for the targeted Fed Funds rate quarterly. The most recent iteration valued the ‘long run’ central tendency of the Fed Funds rate at 4.0% sometime in 2016 or later. A 4.0% forecast appears to be more consistent with a Federal Reserve that is concerned about inflation. We think the Fed’s fears of inflation are aggressive based on two primary factors: changing demographics (both in the US and globally) and the synchronization of developed economies on a global basis. The average age of the population in the United States and globally is rising thereby increasing the demand for assets that pay a predictable stream of income. Despite the move lower in yields in the fixed income market, demand has not waned. We partially attribute the inelasticity of demand for fixed income to the aging population in developed economies. We believe the strong demand for fixed income will cause the differential between short maturity Treasury notes and the Fed Funds rate to contract on a secular basis, which will also lead to lower rates than would otherwise be the case.

Appropriate Pace of Policy Firming

The economic slowdown since the financial crisis of 2008 has impacted the global economy, not just the United States. All of the major developed country central banks (Federal Reserve, European Central Bank, and the Bank of Japan) are easing monetary policy to try and stimulate aggregate demand and to grow their economies. The economies of Europe and Japan also face significant demographic hurdles due to aging populations and are arguably in a more precarious situation than the United States despite the upcoming retirement wave of the baby boom generation domestically. If the Federal Reserve were to prematurely and aggressively tighten domestic monetary policy before the global economy was strong enough to absorb the change, the dollar would strengthen relative to other global currencies, likely leading to a domestic economic slowdown. We believe the Federal Reserve has an incentive to keep rates low relative to other developed economies to keep dollar based manufacturers competitive.

So where do Treasury rates normalize after monetary policy is no longer accommodative? If we assume the Federal Reserve will be able to keep the inflation rate at their long-run target of 2.0%, it is difficult to envision the Fed Funds rate trading at much of a premium to inflation. The demographic shifts mean fixed income assets will not have to offer as competitive a yield versus inflation to attract assets. In a normal environment Treasury yield curves are upward sloping. Therefore, assuming a Fed Funds rate 50 basis points above inflation, Two-year Treasury notes trading at a slight yield pick-up to the Fed Funds rate (approximately 2.75%), and 150 basis points for the term premium for Ten-year yields, 4.25% appears to be a good estimate of Ten-year Treasury yields sometime after 2015.


— William Dennehy II, CFA
            Portfolio Manager




This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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