The Fed’s Policy Pivot: Higher Rates Ahead

The big story last week was Federal Reserve’s hawkish tone. In fact, though, the Fed’s pivot started a few weeks ago, but last week solidified it through the release of the minutes from their December meeting.

There are two key factors that investors are watching: what the Fed plans to do about their bond-buying program known as quantitative easing (QE) and their plans for short-term interest rates.

Regarding short-term interest rates, the Fed indicated that they foresee up to three quarter-percentage-point increases in 2022 and 2023, with the possibility of two more in 2024. All told, that would take the Fed Funds rate to two percent in the next few years.

The market is already pricing in these hikes. The Chicago Mercantile Exchange (CME) Fed Watch Tool suggests that there is an over 80 percent chance of a hike in the March meeting. By year-end, the central estimates show rates between 0.75 and 1.25 percent.

The second issue, how to deal with QE, is a little trickier because the Fed doesn’t want bond prices to shift too far too quickly. They are a huge buyer and if they turned into a huge seller overnight, interest rates would shift dramatically, which is not what they want.

The first step is to slow down their purchases, a phrase known as tapering. When the then-Fed Chair Ben Bernanke first talked about tapering off their purchases in 2013, the bond market sold off sharply in what is now called the ‘taper-tantrum.’

The tapering this time around began in November when bond purchases totaled $120 billion per month, but those purchases are scheduled to end in March.

The last time around, following the 2008 financial crisis, the Fed kept its balance sheet steady for about three years after it finished tapering.

After that time, when short-term interest rates were about one percent, they moved from tapering to what is called quantitative tightening, or QT. Quantitative tightening is when they actually let the bonds they hold mature without replacing them, which shrinks their position in Treasury bonds.

Most analysts seem to think that QT could happen a lot faster this time around, starting at the end of this year, thereby skipping the three-year hold-steady policy.

Long-time readers know that higher interest rates mean lower bond prices. Last year, the Bloomberg Aggregate Bond index (formerly Barclays Aggregate Bonded index) lost about -1.5 percent. So far this year, it’s off another -1.5 percent or so.

That’s the bad news. The good news is that the yield is now higher on our bond portfolios. As much as we don’t like to experience a loss, we want interest rates to go higher.

I’ve said for years (when interest rates principally fell), as long as your time horizon is longer than the duration of your bond portfolio, be happy about higher rates – you get paid more in the long run.