It was 2004: the New England Patriots won their second Super Bowl, Facebook was launched and the US Federal Reserve raised interest rates for the first time in four years—the start of a two-year cycle of rate hikes. To markets, it seems like a distant memory.
The Fed's last rate-raising streak ended in June 2006. Now, nine years later, the market's still waiting for the Fed to ratchet up rates. While the timing of its next move is still up in the air, the Fed seemed to indicate at the end of 2014 that mid to late 2015 may be a starting point—and many economists concurred with that forecast. Meanwhile, the Fed continues making major preparations for policy normalization.
It's been a long time since investors experienced the effects of a Fed rate hike. What difference does such a long lull mean for the Fed? And how should bond investors position themselves?
Whenever the Fed decides to act, the process will look very different in 2015 than it did in 2004.
For starters, the Fed will use new tools—and terminology. The federal funds market was a major tool last time around. Banks used it to lend to each other, and that ultimately helped determine the fed funds rate, which decides all other US interest rates. But today, the market is a shadow of its former self. Before the global financial crisis, roughly $300 billion traded in fed funds daily; today, roughly only $50 billion trades daily. Many banks no longer need to tap that market for liquidity, because the Fed has provided plenty through quantitative easing and other programs.
A shrunken fed funds market removes one of the Fed's key influencers for raising short-term rates. With a massive $4.4 trillion in reserves on its balance sheet—courtesy of quantitative easing (Display)—the Fed won't be able to rely on draining reserves to raise interest rates. It will need to use new tools to nudge short-term rates higher—tools that will likely have a broader impact. Policymakers have been testing these tools the past couple years.
One of the Fed's new tools that it has been testing recently is the overnight reverse repurchase agreement program (ON RRP). These overnight "reverse repos" enable banks (and now other types of Fed-approved investors) to park cash at the Fed for a short period of time. Money-market investors who use the program will have a new counterparty to invest their short-term cash with.
In exchange, the Fed will provide Treasury notes as collateral—typically overnight. Since the Fed can set this overnight rate, it can raise "repo" rates—and hopefully push other market rates higher.
With today's bloated reserve system, the ON RRP program will have to do the heavy lifting with rates. We think the program could be massive, much larger than the current $300 billion cap. It could add some uncertainty and volatility when the time comes to normalize rates. The program may be also be temporary—until the fed funds market starts up again.
As investors wait for rates to rise, the Fed is getting ready to roll out a new lever. The good news for bond investors? The ultimate impact on fixed-income markets should be the same—and we believe that classic bond strategies are still the way to go.
So, whenever the Fed decides to take action, the bond playbook will look like a flashback. The main focus is balancing interest rates and credit. As for rates, we think going global can reduce exposure to single-country interest-rate risk and provide opportunities to add value from active management. If taxes are a consideration for US investors, muni bonds can help reduce the impact of rising Treasury rates. And positioning along the yield curve is critical to taking advantage of roll, the tendency of a bond's price to rise as it moves closer to maturity, assuming rates don't change. The steeper the yield curve, the more attractive the roll.
On the credit side, it's important to be selective, because there aren't many areas of the market that are uniformly cheap today. Investors should also avoid diving into crowded trades such as high-yield loans and CCC-rated high-yield bonds. Diversifying across multiple credit sectors can expand the opportunity set while providing added diversification.