Why Does the Bond Market Not Believe the Fed?

One of the most highly anticipated Federal Reserve Open Committee meetings in recent memory, the September FOMC meeting, gave the market insight into the Fed’s long term economic and interest rate projections. Interestingly, the market seems to disagree with the Fed on all fronts. Arguably the most important portion of the release as it relates to the bond market is the summary of interest rate projections, whereby Fed governors publish their expectations for where the Federal Funds Rate will be over the next 3 years and over the long-term. As shown in the chart below, the Fed is predicting significantly higher rates than is the market based on where interest rate futures are currently trading.

Why the disconnect? We think interest rates are being held down because of global factors, which are not generally included in the predominantly U.S. focused Fed projections. Treasury bond yields have fallen over the course of the year despite continuing improvement in U.S. economic data. The relationship between the strength of the domestic economy and the direction of rates, which is generally positively correlated, has experienced a negative correlation in 2014. We learned recently that the Eurozone failed to produce any GDP growth in the second quarter, a worrying sign for the global economy. Japan’s GDP fell nearly 7% in the second quarter due to a significant tax increase that went into effect recently, pulling spending forward to the early part of the year. In addition, geopolitical tensions from the Middle East to Russia/Ukraine have created a "flight to safety" bid for U.S. Treasury bonds, which are thought to be the safest and most liquid assets in the world. The question now becomes, can the U.S. economy continue its decoupling from the rest of the world, as the Fed seems to expect? Given the fact that the majority of our economy is driven by service and consumer spending, we think that the recent domestic strength can continue. The improving employment picture and stronger household balance sheets should lend support to consumer spending. Inflation has likely bottomed and is approaching the Fed’s target levels. These factors will likely lead to monetary policy normalization in mid-to-late 2015 and higher rates.

In short, if both we and the Fed are correct in this assessment, bond investors should be cautious in evaluating interest rate risk. With rates still at historically low levels, there is not much reward for taking significant risk. We think the prudent course of action is to be conservative with bond investments at this point in the cycle, as better opportunities to take risk may present themselves in the not too distant future.

Source: Bloomberg