When will interest rates rise? There’s hardly a more compelling question for bond investors. The answer depends on when the U.S. Federal Reserve Board will end its US$85-billion monthly purchase of treasury bonds, known as “quantitative easing” (QE). For financial advisors, there’s a gap in guidance; for your clients, there’s heightened risk in the absence of certainty.
Market-watchers’ predictions on when the Fed will start tapering off its QE program have been useless. Fed announcements in the summer and autumn that tapering was about to begin were warning shots of what’s to come, but the timing of the reductions and the amounts remain unknown.
“It’s an interest rate conundrum, says Graeme Egan, portfolio manager and financial planner with KCM Wealth Management Inc. in Vancouver. “We think rates will go up within 12 to 18 months, but we think that what the Fed has done is take a position rather than act.”
The ground rules, as Fed chairman Ben Bernanke says, are that when the U.S. unemployment rate drops to the low 7% range, the Fed will taper off its QE, which makes it cheap for banks to finance themselves, keeps interest rates down and supposedly stimulates economic recovery.
When Bernanke deferred any tapering in September, markets were almost giddy with delight. It meant that bonds would hold or gain value, which they did, and that money would stay and grow in stocks, which happened.
There is the question of what the monthly injection of cash into the financial system has done. The results are good, in that things have not gotten worse, that more large banks did not crash in the style of Lehman Brothers Holdings Inc.; but also underwhelming, in that things have not gotten better.
For instance, unemployment in the U.S. declined to 7.3% of the labour force in September while the participation rate – people looking for jobs or working – dropped to 63.2%, which number-crunchers at the U.S. Bureau of Labor Statistics say is a 35-year low. The shutdown of much of the U.S. government in early October trashed these data; but, now that the government has resumed its business, the numbers should get no worse.
What’s ahead should reflect economic realities. First, there’s the rather American phenomenon of price supports. After all, a price-support program for treasury bonds is not unlike federal crop-price supports following the Great Depression of the 1930s – as well as former president F.D. Roosevelt’s New Deal. Money injected into markets to buy wheat, corn and soybeans kept prices of those commodities up. QE bond buying is no different.
The trouble, however, is that such price supports are habit-forming, says Marc Stern, vice president with Industrial Alliance Securities Inc. in Montreal: “Fed bond buying is akin to heroin for an addict. Once you are on it, it’s hard to be weaned off.”
Bond-market watchers have a less cynical view but no consensus. A survey by Bank of Nova Scotia‘s economics department released in September shows a range of timing predictions for a pullback in QE, from late October by wholesale broker Cantor Fitzgerald LP (the earliest of all forecasts) through the most popular view (held by seven big securities firms, including HSBC Securities [Canada] Inc.) that it will be in December to Scotiabank’s view (along with Credit Suisse and Daiwa Securities Group Inc.) that it will happen in January 2014. The outlier is Mizuho Securities USA Inc., which believes the pullback will take place in March.
The expected size of the initial reduction in QE is US$10 billion-US$25 billion; the consensus is US$12 billion.
Craig Wright, chief economist with Royal Bank of Canada, suggests that without Fed intervention, five-year U.S. treasuries’ yield should rise to 1.6% by the end of 2014 from 1.4% today, and 10-year U.S. treasuries’ yield should rise to 3.6% from 2.65% today – assuming 2.7% growth and 1.8% inflation. It would take time, he adds,. to get to these historical norms.
In Canada, given the absence of bond-buying programs on the U.S. scale, five-year Government of Canada bond rates would rise to 2.7% from 1.85% now, and 10-year rates could rise to 3.4% from 2.54% now. This should happen by mid-2015, says Avery Shenfeld, chief economist with CIBC World Markets Inc. in Toronto: “There’s not likely to be much movement in the next six months. The moves will only come when the Canadian and U.S. economies have shown the ability to sustain a higher growth rate.”
The Fed’s path to normalization of the bond market is strewn with risks. Bond sell-offs tend to be massive when large, fundamental events take place. The biggest on record was the 38% average loss in values between June 1980 and August 1982, following the decision by then Fed chairman Paul Volcker to jack up interest rates to control raging inflation.
The average length of a 5% or larger bond sell-off, if you date the inflationary period that drove rates up and prices down, is 303 calendar days; the shortest is 16 days; and the maximum is 1,309 days. The Fed has to avoid the slaughter as it cuts back on its QE.
“Take the view that the Fed will taper no later than March 2014,” Stern advises. “You can hold your existing government bonds, but I would not advise clients to add to those positions now. If you do want to add to a fixed-income position with investment-grade bonds, keep durations down to one year or less.”
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