Last Wednesday, Janet Yellen presided over a press conference as the new Chairman of the Federal Reserve (Fed) following the conclusion of the Federal Open Market Committee's (FOMC's) two day meeting and the release of the official FOMC statement. Markets hung on every word and some confusion was created afterwards as Yellen offered a more transparent look at the Fed's timeline for raising interest rates. To be specific, when the Fed discusses the topic of "raising interest rates" it is referring to the Federal Funds Rate, which is the interest rate at which institutions lend funds maintained at the Federal Reserve to other institutions. The Federal Funds Rate is often looked at as a benchmark for other interest rates and has a profound influence on overall economic activity as its level can either help to stimulate the economy or control inflationary pressures. The FOMC sets targets for the Federal Funds Rate and looks to achieve these targets through their own open market operations.
In its recent statement, the Fed said it would no longer be considering the unemployment rate, in isolation, as a barometer for when to begin raising interest rates and instead would now consider a wide range of information including measures of labor market conditions, indicators of inflation pressures, inflation expectations and readings on financial developments. The Fed reiterated that its outlook for the economy and monetary policy remains unchanged.
At one point during the press conference, Yellen was asked to clarify her following statement:
"The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends."
In her explanation, Yellen said her expectation for the first increase in the Federal Funds Rate would come approximately six months following the end of the asset purchase program. Based on this statement, we have created the following potential timeline.
- Should the asset purchase tapering process continue on a pace of a $10 billion monthly reduction following each of the Fed's eight scheduled meetings this year, this would then conclude the tapering process toward the end of 2014. As a point of reference, the Fed was purchasing $85 billion of bonds each month at the end of 2013 and reduced the pace by $10 billion to $75 billion per month in January 2014. The Fed further reduced its bond purchases by $10 billion to $65 billion per month in February 2014 and finally just announced another $10 billion reduction to $55 billion per month beginning in April 2014.
- Should the tapering process be completed by the end of 2014, and we tack on the six month window as suggested by Yellen, the first potential increase in the Federal Funds Rate would then take place during the spring time of 2015.
If a Federal Funds Rate increase were to occur in the spring of 2015, this would represent the first rate increase in over eight years as the last increase in rates occurred in June of 2006. It would also be the first time in over six years that the federal funds rate would not fall within its current 0.00%-0.25% target range.
Once the Fed begins to raise interest rates, we believe that they are likely to use the 2004-2006 timeframe as a blueprint for the tightening program this time around. During this previous time period, the Federal Funds Rate was gradually raised on 17 different occasions over a three-year time period - specifically from July 2004 - June 2006, in equal increments of 25 Basis Points (i.e. 0.25%) each time.
However, even if the Fed does not begin to raise interest rates until 2015, that does not mean that bond yields cannot further increase in 2014. One needs to look no further than the chart below to see how much yields can rise when the perception of rising interest rates change - even though the Fed actually did not take any action with respect to the tapering or raising interest rates in 2013. In this regard, according to economic research data from the Federal Reserve Bank of St. Louis, yields on 10-Year U.S. Treasuries went from 1.66% on May 2, 2013 to 3.04% on December 31, 2013 - a relative increase of over 83%.