Federal Reserve Chairwoman Janet Yellen has made it clear that tapering is on a pre-set roadmap and that interest rates will begin to rise no sooner than six months after the Fed's asset purchases end. We see the specific timing becoming increasingly dependent on U.S. inflation, and financial markets agree, as shown in our chart below on inflation sensitivity.
Call it luck or a get-out-of-jail-free card, but the Fed is executing taper just as there is a flight to quality into U.S. Treasuries as a result of geopolitical uncertainty in Ukraine. Helping the Fed further is the secular shift in China toward liberalizing the renminbi to combat the unprecedented depreciation of the Japanese yen. Beijing's need to depreciate the RMB will likely be accomplished by buying U.S. Treasuries, compensating for the Fed's withdrawal of liquidity.
Looking past the debate about what day of the week or what month of the year the Fed will hike interest rates, we can gather insight about what that world will look like from the last tightening cycle. When the Fed, under the stewardship of Dr. Alan Greenspan, last began to raise interest rates in 2004, they borrowed a leaf from the Bundesbank's book of monetary policy tricks and did so in gradual increments of 25 basis points at every Federal Open Market Committee meeting. With the Fed now very concerned about behaving in a predictable manner, once Dr. Yellen decides the time is right to start tightening, we can again expect gradual incremental hikes of 25 basis points at every FOMC meeting. Such a path would see interest rates starting to rise at the earliest in mid-2015, adding two percentage points to the fed funds target rate every year.
We know from every business cycle in the post-war period that as the Fed continues raising rates the Treasury yield curve becomes flatter, and in time, the 10-year U.S. Treasury note actually trades below the fed funds rate. Understanding how yield curve shifts occur during periods of tightening monetary policy will be crucial as investors position portfolios for the realities of a more restrained monetary environment. All of this suggests increasing exposure to floating-rate instruments while retaining flexibility to take advantage of intermittent flights to quality.
U.S. Markets Increasingly Sensitive to Inflation
With tapering of the Federal Reserve's asset purchases unlikely to deviate from its pre-set course of a $10 billion reduction per FOMC meeting, speculation is rising about the timing of the first increase of the federal funds target rate. The catalyst for the Fed to hike rates will likely be rising inflation, which is increasing investor sensitivity to inflation data as the inevitable rate hike nears. Since the beginning of QE3, inflation surprises (core CPI data above or below consensus expectations) have become increasingly correlated with volatility in the 10-year U.S. Treasury yield, suggesting inflation is becoming a bigger focus for investors.
ROLLING 36-MONTH CORRELATION OF INFLATION SURPRISES* AND 10-YEAR U.S. TREASURY VOLATILITY
Source: Bloomberg, Guggenheim Investments. Data as of 3/18/2014. *Note: We define inflation surprises as the difference between the core CPI month-over-month percentage change and Bloomberg's median forecast. Core CPI is used because it is the first inflation data point released (i.e. before Personal Consumption Expenditures).
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