According to the latest minutes of the Federal Reserve (Fed) monetary policy meeting the first rate hike in the US in many years might come before year-end. Although markets have increasingly priced in such a scenario in the aftermath of the latest jobs report (published on 6th November), until Wednesday the implied probability of a status quo was in the 40% region. The minutes published this week pushed this higher as they spoke of balanced growth risks, resilience of the US financial system and lessening concerns about global economic and financial developments. It was also pointed out by some participants that “a decision to defer policy firming could be interpreted as signalling lack of confidence in the strength of the U.S. economy or erode the Committee’s credibility. Some participants emphasized that progress toward the Committee’s objectives should be assessed in light of the cumulative gains made to date without placing excessive weight on month-to-month changes in incoming data”.
Overall a rate hike in December appears to be in the making. Having said this, the minutes were not altogether optimistic as they repeatedly pinpointed to persistent challenges that are likely to result in a slow and limited increase in interest rates. Indeed, the minutes make several references on these lines: “the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation”.
Indeed, the committee discussed several factors that suggest that interest rates will rise by less than in the previous cycles. What is more, the participants went one step further by saying that a lower long-run level of rates “would also imply that the gap between the actual level of the federal funds rate and its near-zero effective lower bound would be smaller on average. A smaller gap might increase the frequency of episodes in which policymakers would not be able to reduce the federal funds rate enough to promote a strong economic recovery and rapid return to maximum employment or to maintain price stability in the aftermath of negative shocks to aggregate demand. Some participants noted that it would be prudent to have additional policy tools that could be used in such situations.”.
To put it differently, the global economy has indeed migrated towards a lower rates environment and in such a context non-traditional monetary stimulus (such as Quantitative Easing) might become quite traditional.
What does all this technical rhetoric mean for markets? As we have been anticipating for some time now, the tightening of the Fed monetary policy is likely to mostly affect the short to medium term yields and leave the longer term yields relatively unscathed as the latter are more sensitive to the longer term prospects than to short term rates. Indeed, the 2 year US sovereign yield reached multi-year highs, while the 10 year yield has been range trading throughout the year.
This means that, contrary to the customary belief that longer maturity corporate bonds are more susceptible to rate hikes, during this cycle investors might be better off putting their money in notes with over 5 years maturity. Having said this, for the lower rated names most of the bonds have maturities of 4-7 years. Even so, they should not be avoided as the positive economic outlook that brought the rate hike in the first place should help diminish the credit spreads (i.e. the premium over government yields) and hence result in lower overall yields (and higher prices). It goes without saying that this strategy does not apply indiscriminately to all issuers, and sector and name selection remains of paramount importance.
Have a nice day!
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