From a Marketwatch news article published July 6, 2014:
“LONDON (MarketWatch) -- Goldman Sachs now believes the first hike in the U.S. federal funds rate will come in the third quarter of 2015, rather than in the first quarter of 2016. The changed forecast comes in response to "the cumulative changes in the job market, inflation, and financial conditions over the past few months," chief economist at Goldman Sachs, Jan Hatzius, said in the note from Sunday. The revised forecast is close to current market expectations, but Hatzius said the change is important because it is the first time since the crisis that Goldman Sachs has moved forward its rate-hike expectations. "We view this as an illustration of the substantial progress that the U.S. economy has made in overcoming the fallout from the housing and credit bubble," he said. Goldman Sachs now expects the funds rate to rise gradually back to 4% by 2018.”
Seeking Alpha’s reading of the Eurodollar futures seems to agree with the Goldman Sachs’ belief and offered the following news headlines on July 7, 2014:
“Checking Eurodollar futures for expectations of tighter monetary policy, they've backed off a bit from rate hikes as well, the June 2016 contract ahead by four basis points, but still pricing in a Fed Funds rate about 130 basis points higher in two years then it is now.”
http://seekingalpha.com/news/1833425-treasury-yields-reverse-post-employment-report-surge
The current yield curve for US treasury notes/bonds is below. Based on the curve, the 10-yr is yielding 2.65%, 20-year is yielding 3.21%, and the 30-year is yielding 3.47%
Yield Curve July 5, 2014, www.treasury.gov
If 10-yr rates are expected to increase to 4.0% and based on the same yield curve slope, one should expect yields to increase to 4.56% on 20-yr and 4.82% on 30-yr, for a net increase of 1.35% across the board.
Below is a graph of historic 2-yr and 10-yr rates going back to 2004. As shown, before the 2008 financial debacle, both 2-yr and 10-yr rates were in the 4.0% range, and it was not until the easy money of the past few years that rates dramatically declined.
In addition, the Modified Taylor Rule adds another layer of agreement with rates climbing dramatically after 2015, as shown below. The chart outlines how the Modified Taylor Rule has mirrored the Fed Funds rate from 1985 to the current crisis’ beginning in 2008.
Modified Taylor Rule and Fed Funds Rate. www.brookings.edu
“A simple, but highly effective way of transforming output gap estimates into monetary policy comes from the Taylor Rule, which is based on John Taylor’s 1993 paper Discretion Versus Policy Rules in Practice. It calculates a recommended federal funds rate based on only three variables: the amount of slack in the economy; the deviation of inflation from its target; and the neutral interest rate described above. While there is much disagreement about the exact definition of these variables and the appropriate weights on them, the modified Taylor Rule depicted in Figure 3 seems to do a very good job at modeling Fed behavior.
The modified Taylor Rule suggests that the fed funds rate should’ve been cut well below zero during 2008 and should remain negative today. Since it is very difficult to charge negative interest rates, the Fed came up with alternate policies, such as expansion of its balance sheet to initially ease up frozen credit markets in 2008-09, then to lower longer-term interest rates as well as encourage credit creation and risk taking today. Though the latest jobs report of weak payrolls but a lower unemployment rate present a confusing picture of the economy, the modified Taylor Rule currently recommends that since the economy is recovering and starting to eat into the spare capacity - as evident by the declining unemployment rate - interest rates should not be as negative as before.
Using the latest FOMC Economic Projections (Table 1) in combination with the CBO’s estimate of potential, we can attempt to forecast monetary policy going forward (see the right hand side of Figure 3). The modified Taylor Rule forecasts that the Fed will start raising interest rates at the end of 2014, and the funds rate should be above 3% by the end of 2016.”
More information on the Modified Taylor Rule can be found here:
http://en.wikipedia.org/wiki/Taylor_rule
http://web.stanford.edu/~johntayl/Papers/Discretion.PDF
A inescapable fact is that bond prices in the secondary market react inversely to interest rate movements. As interest rates go up, bond prices go down; as rates go down, bond prices go up. So what does this mean for bond investors? In a short sentence – it means a massacre of long bond prices is in the offing. IF the yield curve does not steepen and IF long rates are held to only a 1.35% increase, the following ETF/bond funds will decline by the following percentages:
ZROZ PIMCO 25 Year+ Zero Coupon Treasury Bond will decline by 37.15%
EDV Vanguard Extended Duration Treasury Bonds will decline by 33.75%
TLT iShares 20 Year+ Treasury Bond will decline by 22.1%
TLH iShares 10-20 Year Treasury Bond will decline by 13.1%
IEF iShares 7-10 Year Treasury Bond will decline by 10.2%
Below is a Morningstar graph of the cumulative inflows and redemptions of bond vs. stock funds for the 5-years from 2008 to 2013. As shown, the inflow for bond funds is about five times the outflow of stock funds.
Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com
What to do?
The first step is to determine your personal interest rate risk by fund or ETF. Morningstar.com on its quote offers the average duration, or the ratio of rate sensitivity, for almost all bond funds and ETFs. To calculate a specific bond fund’s interest rate exposure, multiply the anticipated rate movement by the duration. For example, ZROZ has duration of 27.5 and the example above is a 1.35% rise in rates. Multiply 27.5 x 1.35 = 33.75, or a decline of 33.75%.
While floating rate ETFs and funds have no duration as they reflect the current rate environment, duration of 4.0 or less would be considered low. The easiest means of lowering duration would be to shorten maturity exposure.
Bond investors are facing a difficult choice – reduce short-term income by moving out of higher yielding, longer term and higher duration investments. Which is better for you 1) reduce your income over the next few years or 2) experience a considerable loss of principal? It is like the deciding the better of two evils.
I appreciate your time and interest in Guiding Mast Investments, George Fisher