The Fed and the Taper Talk
This summer, the FOMC’s speeches and official statements have been focused on tapering the pace of the Federal Reserve’s asset purchases. Both the equity and fixed income markets have been hanging on to the Fed’s every word and the markets’ interpretation of the FOMC’s comments have led to a significant sell-off in longer-term yields, while the front end of the curve remains anchored by the Fed’s near-zero overnight rate target. Over the past two months, two- and 10-year treasuries had yield swings of 14 (0.14%) and 66 (0.66%) basis points, respectively.
Predicting the turn in any rate cycle is just as difficult for the FOMC as it is for the market as a whole. Over the years, the Fed has learned to be open and clear with its intentions so as not to surprise the markets. Unfortunately, these communications and subsequent market interpretations can cause volatility and anxiety over investment strategies. Should one shorten duration exposure? Should one increase floater positions?
Before one fusses over any one specific strategy, it’s important to recognize this rate cycle is very different from past rate cycles. In the past, the FOMC’s first lever of choice was talking up interest rates, which was followed by adjustments to the fed funds rate. In the current cycle, reducing the Fed’s balance sheet likely will significantly precede the first adjustment to the fed funds rate. In this scenario, one needs to separate the yield curve impact of the Fed’s tapering strategy with the yield curve impact of a fed funds rate increase and understand the time lapse between the two. Certainly, longer-term mandates – those beyond two years – will feel the pain of the possibility of tapering over the next year due to steepening of the yield curve, while the short part of the curve still will be firmly anchored by the current fed funds rate. Due to the new dynamic of this rate cycle, this month we thought it would be constructive to discuss the impact of the Fed’s tapering of asset purchases on short-duration investors versus the fed funds rate.
Best Regards,
Ben Campbell
President & CEO
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