In May, we said that as soon the Fed intimated to the markets that it would begin tapering its quantitative easing program, interest rates would rise by 100-150 basis points. In the Federal Open Market Committee's May statement, it added the following new language: "The committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes."
This provided the market with its first hint that the FOMC was contemplating reducing its asset-purchase (QE) program, precipitating the recent rise in interest rates.
Later in the month, in response to questioning from the Joint Economic Committee, Federal Reserve chairman Ben Bernanke was more specific, saying the FOMC could begin reducing asset purchases as soon as a few meetings from May. Soon thereafter, the FOMC released the minutes from the April 30-May 1 meetings. These minutes highlighted the fact that a number of members believed the current asset-purchase program should have been decreased as early as the June meeting (with one participant recommending beginning decreasing purchases immediately).
Since the beginning of May, the 10-year Treasury has risen 120 basis points and is nearing the bottom of the range that we think reflects a normalized level. Interest rates continued to rise last week, with the 10-year hitting an intraday high of 2.92%, before Treasury bonds rallied Friday after poor new-home sales data was released. As the 10-year approaches 3%, we think the pace at which interest rates are rising will moderate.
One of the reasons we believe this is that the Fed has committed to keep short-term rates near zero until unemployment decreases to 6.5% or inflation increases over 2.5%. As such, shorter-term interest rates have not risen at the same pace as longer-term rates. While the 10-year Treasury has risen sharply, the 2-year bond has risen much more slowly, leading to a significant increase in the steepness of the yield curve.
We think corporate bonds will probably continue to struggle over the next month as investors attempt to anticipate the timing of when and how quickly the Federal Reserve will taper its asset purchases and forecast the bond market's reaction. Given economic improvement (gradual employment growth and inflation returning to targeted level) and technical reasons (lower deficit provides fewer bonds to purchase and the already high percentage the Fed owns in long-dated bonds), we think the Fed will most likely begin to taper its asset-purchase program after the September FOMC meeting.
On average, since the mid-1970s, the spread between the 2-year and 10-year Treasury has been 90 basis points. Currently, the spread is 250 basis points, which is only 40 basis points from its widest point (which occurred in February 2011) and about 2.5 standard deviations higher than average. In addition to the steepness of the curve, as the market prices in a higher probability that the Fed tapers its asset-purchase program in the near term, inflation expectations have moderated. For example, the five-year, five-year forward (the market implied average annual inflation rate expectation for five years, five years in the future) has decreased to 2.40% from 2.80% at the beginning of the year. As the yield curve has steepened and forward-looking inflation expectations have moderated, investors should be willing to extend out the curve to pick up additional yield and benefit from the roll down in the curve over time.
