The biggest debate in the market right now is if the Fed is “behind the curve” when it comes to tackling inflation. And if it proves that they are, the expectation is that they have to raise interest rates sooner than anticipated. This isn’t necessarily a bad thing, and there’s already signs the market is preparing for it anyway.
Tracking market expectations
Tracking the market’s expectations for the Fed to raise rates is very easy thanks to the CME’s Fed Watch tool. The tool looks at interest rate futures and determines a market probability for future interest rate decisions. For example, the Fed currently has the target rate set to 0.00-0.25% and the market currently sees a 0% chance that the Fed will raise interest rates at its next meeting this December. But there is a 5% chance that they will raise them in January of next year according to the CME’s fed watch tool.
December probabilities show the market expects the fed to leave their target rate unchanged, at 0.00%-0.25%:
January probabilities show the market largely expects the Fed to leave their target rate unchanged, at 0.00%-0.25%:
These expectations can help us form a basic assumption: if the Fed raised rates at either its December or January meeting, the market would be caught off guard. We don’t think that will happen. What’s nice about this tool though is not only does it show us where expectations are today, it shows us where they were one month ago. This allows us to evaluate how quickly the market’s expectations are shifting, and if there is momentum towards an earlier interest rate hike than previously anticipated.
The first hike is likely coming by June or earlier
When we look at the market’s expectations for May or June, it does appear that momentum is building towards an expected interest rate hike.
The probability for a hike by May is up to 31%, compared to 16% one month ago:
For June, the probability is up to 69%, with a 19% chance that the Fed will hike rates two times as opposed to just once. This compares to one month ago, when the market still assigned a 61% chance that there wouldn’t be any interest rate hike at all:
You can see there is clearly momentum building for an interest rate hike. And these expectations are important because the Fed has a history of delivering what the market is expecting. So in a way the interest rate hikes can become self-fulfilling; as the market expects hikes sooner and sooner, those hikes become more and more likely. The Fed does not like surprising the market.
How does this impact the bond market?
The general presumption is that if the Fed raises interest rates it will have a negative impact on the bond market. But the details are more nuanced. The Fed controls a very short-term focused interest rate, so if they do raise rates, the impact will be most felt in short-term bonds like those with durations of 1-5 years. We’re already seeing this start to play out in the bond market, as shown by ETFs that track the government and corporate bonds with 1-5 year maturities, like VGSH & SPSB. As expectations for an interest rate hike have increased in the last month, these short-term bond ETFs have fallen 0.25% and 0.33%, respectively:
Bond prices and interest rates move in opposite directions, so as yields rise, bond prices fall. Thus, the performance of these two ETFs should not be much of a surprise. Interest rates, and expectations of higher interest rates, are rising, as a result, bond prices are falling. Where the surprises start to show up is on the longer end of the curve, with bonds that have maturities of 20 years or more. Longer duration maturities are typically most vulnerable to changes in interest rates. Therefore, you might think that if short-term bond prices are falling recently, long-term bond prices are probably falling even more. But that’s not necessarily what we’re seeing.
TLT, an ETF that holds government treasuries with more than 20 years until maturity, is flat over the last month, and was recently up more than 3% in the period. IGLB, an ETF that holds corporate bonds with more than 20 years until maturity, is lower by just 0.60% over the same one month period:
Why would long-term bonds hold up better than short term bonds?
The fact that a long term treasury ETF is out performing a short term treasury ETF over the last month may come as a surprise. After all, if interest rates will be higher tomorrow than they were yesterday, why would you own a bond issued yesterday, at a lower interest rate, when you can buy a bond tomorrow and earn greater interest? Herein lies why we said the details are more nuanced…
If we think about Fed policy and what they are trying to do when they raise interest rates it is mainly to tame soaring inflation. In general, when the Fed raises interest rates, it is a form of tighter monetary policy that can (though, not always), slow down the economy. If their policy decision does indeed slow down the economy and lower inflation, which bonds benefit the most? Long term bonds. Why? Because in a slowing economy with low inflation, long-term bonds will have the highest yields. Those higher yields are attractive to investors in a slowing economic environment.
In summary, here is what we know:
- The market is expecting the Fed to raise rates by June, but there is momentum building for an even earlier rate increase. You can track the market’s expectations yourself here.
- Bond prices, in general, have fallen as the market braces for higher interest rates. But long-term bond prices are holding up better than you might expect.
- Long term bond prices may actually rise in value in a rising interest rate environment due to the expectation of slower economic growth and less inflation in the future.
For the stock market’s part, it has so far taken all of this information from the Fed and the bond market in stride. It remains very steady and is trading near all time highs. We’ll be keeping a close eye on the market’s expectations for interest rates and how both the bond and stock market finish out the year.
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