The bond market changes its mind on the interest rate outlook

The bond markets are currently anticipating increases in interest rates—but the pace of those anticipated increases is notably slower than it was at the turn of the year. And when we turn from the short-term federal funds rate that dominates the headlines to the longer duration instruments that matter most to institutional investors, the future rate of change that is currently priced in is slower still.

Today’s bond prices contain information about anticipated future moves

The U.S Treasury forward curve tells us a lot about the market’s changing view on the interest rate outlook. In simple terms, the forward curve gives us an indication of the market’s expectations for how bond yields will change in the future¹. (A fuller description of how this works can be found at this link.)

For example, the forward curve at the end of 2015 (shortly after the long-anticipated and much talked-about first federal funds rate increase in over nine years) shows the market’s expectations for further increases in the years to come. In the chart below, the solid grey line shows the yield on a 1-year Treasury bond over the ten years to the end of 2015, and the dotted line shows the changes in that yield that were priced in to the market at the turn of the year: from a year-end value of 0.65%, the forward curve implied an increase to 1.5% over 2016 and to around 2.9% by the end of 2020.

That was then.

Treasury rates - historical up to Jan 2016; forward rates for Feb 2016 and later Source: U.S. Treasury; Russell Investments

A change of sentiment

Although it is the sharp sell-off in the equity markets that has received most of the attention, the bond markets too saw significant changes to start the year. At the end of January, the one –year Treasury yield had fallen by some 0.18% and the expectations for future increases—shown by the dashed grey line—had pulled back even more sharply. Rather than passing 2% in the first half of 2018, the yield is now priced not to hit that level until the second half of 2019.

The main driver of the short-dated Treasury bond is market expectations around monetary policy: i.e. what the Fed will do. Expectations around monetary policy are in turn largely driven by the short-term outlook for the economy and for inflation. The Fed itself recently stated an expectation that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate” so there’s good reason not to get carried away.

The change in January points to a less optimistic economic outlook. So did the outlook really deteriorate? Or were markets too optimistic late last year? Or did they overreact in January?

The view of Gerard Fitzpatrick—Russell Investments’ CIO of Fixed Income—is that: “There is excessive momentum and sentiment out in the market place, distorting both treasury and credit markets. Our view is that yields will rise higher than what the forward market currently reflects. Recognizing the downside risks coming from low oil and Chinese growth, we still feel the US domestic economy is on strong footing backed by a strong labor market in 2016. This view backs up how our strategists assess markets and how we’re handling the risks within our portfolios.”

Longer duration yields matter more to institutional investors

For institutional investors, it’s not the Fed rate or the one-year treasury yield that really matters, though: both assets and liabilities are more closely tied to longer duration instruments. The 1-year and longer-duration Treasuries are related, but they’re not the same. Long term yields are affected by a wider range of supply/demand pressures, not just by expectations about the Fed. So, even though loose monetary policy meant the 1-year rate remained low and stable from 2009 through mid-2015, the 10-year rate moved significantly up and down several times during that same period.

So in the second version of our chart—below—we add the 10-year Treasury yield. And here we see that, even at the end of 2015, the market’s expectations of increases were much more gradual; indeed, the 1-year and 10-year yields were projected to be essentially equal by the end of 2020. But although the 10-year yield dropped in January, future expected increases remained essentially unchanged (albeit from a lower initial value.) So even though the chart implies an expectation that monetary policy will be very different in five years’ time, it does not imply anything like as big a change in the longer term outlook. History supports this view: when the Fed has raised rates in the past, longer term yields have been much less impacted than short-term.

The future course of interest rates has been the subject of close attention for a long time now, and that doesn’t look set to change. It remains a complex—and fluid—subject.

Treasury rates - historical up to Jan 2016; forward rates for Feb 2016 and later Source: U.S. Treasury; Russell Investments

¹Although I am using the forward curve as an indicator of what the market “expects” to happen, expectations are not the whole of the story. Markets generally price safer assets higher than risky ones, so there is also generally a term premium (higher expected return) baked into the price of longer duration bonds, and this in turn would affect forward curve calculations.