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Due to an improving economy following its previous meeting, the Fed said it will reduce its monthly mortgage and Treasury bond purchases (or quantitative easing) to $35 billion from its current $45 billion level, starting in July. This continues the Fed’s shift in monetary policy from “excessively easy” to “easy”, a process that has been underway since late 2013.

Fed Chairwoman Janet Yellen indicated that short term interest rates would likely remain at near-zero levels even after the central bank ends its asset buying program, citing slower economic growth potential in the near term. The Fed reduced its unemployment projection for the duration of this year, but anticipates faster economic growth in 2015 and 2016. According to the mean expectations of board participants the benchmark federal funds rate is now expected to hit 1.2% by the end of 2015 and 2.5% by the end of 2016. Longer term, the Fed reduced its terminal target fed funds rate interest rate projection from 4% to 3.75%.

I’ve discussed on The Blog how an investor can think of the federal funds rate and QE as a gas pedal. Sometimes it’s good to ease off a bit to limit the pace of acceleration, as a way of more smoothly getting the economy up to long term growth rates.  We still don’t expect the Fed to hit the brakes and push the fed funds rate above the “longer run policy rate”; instead we expect continued declining acceleration. The gradual decrease in mortgage and Treasury bond purchases is the beginning of this reduced acceleration, as we believe the Fed aims to end its bond buying program before gradually increasing the fed funds rate.

My colleague Rick Rieder notes that the new policy outlook provides some unique opportunities for investors, specifically:

  1. Long-end municipals in the U.S. Munis took a considerable hit a year ago when interest rates rose sharply, but have gained momentum in the past two quarters as interest rates have declined and sentiment has improved; we believe there is value to be found here as a source of income in a continued yield challenge environment.
  2. Mortgage-backed securities (MBS). The housing sector continues to improve, and while its recovery has slowed recently, we believe the upward trend will continue.  The continued low level of market volatility is also good for MBS performance.

Rieder warns that one place to be cautious is the short-end of the U.S. Treasury curve (two to five years); we believe valuations are still distorted by current Fed policy.

 

Sources: Federal Open Market Committee, June 18, 2014

 

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here

 

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

Mortgage-backed securities (“MBS”) and commercial mortgage-backed securities (“CMBS”)  are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.

 

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