Fed watch: more tightening

The Fed raised rates in June, and seems poised to do more.

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What the Fed's plans may mean for bonds

Bill Irving, manager of several Fidelity bond funds, expects one more hike in the fed funds rate this year and an unwinding of the Fed’s $4.5 trillion balance sheet.

Treasury inflation-protected securities (TIPs) look cheap relative to Treasuries.

Mortgage-backed securities (MBS) may face headwinds.

Long-term rates may not rise as much as short-term rates.

The Federal Reserve moved to raise rates for the fourth time this cycle, increasing the target for the key borrowing rate 0.25% at the June meeting. The central bank also laid our additional details about plans to stop reinvesting assets on its balance sheet.

Viewpoints spoke with Bill Irving, manager of Fidelity® Government Income Fund, Fidelity® Treasury Inflation-Protected Bond Fund, Fidelity® GNMA Fund, Fidelity® Mortgage Securities Fund, and Fidelity® Strategic Real Return Fund about his outlook for interest rates and the additional tools the Fed could use to handle monetary policy. Irving expects that by early next year the Fed will begin to let its sizable balance sheet run down by paring back reinvestment of maturing Treasuries and paydowns of mortgage-backed securities. We discussed the potential impact on the bond market, and where Irving is seeing investment opportunities.

Q: How healthy is the U.S. economy?

IRVING: I think the Federal Reserve is displaying the most confidence it has had since the financial crisis a decade ago. The economy is essentially at full employment, and risks from abroad, particularly Europe and China, are in remission—at least for now.

The Fed revised expectations for 2017 GDP growth slightly higher, the labor market has continued to gain strength, while household and consumer spending have picked up. On the other hand, inflation has softened somewhat, and remains below the central bank’s 2% target. Several factors contributed to the drop in inflation, from highly competitive pricing for wireless data plans to a glut of used cars hitting the market.

Over the past five years, the economy has been through a number of shocks, including the eurozone crisis, the fiscal cliff, China's surprise currency devaluation in the summer of 2015, and the shale oil bust. Through all of these shocks, the U.S. continued to grow at a real rate of around 2%, and I think that trend remains intact.

Q: What do you expect from the Fed this year?

IRVING: I expect the Fed’s confidence will keep it from being very sensitive to the ebbs and flows of macroeconomic data. I still expect the Fed to raise interest rates one more time this year, likely in September. If inflation continues to stay soft, the September hike could be in jeopardy.

For now, however, the Fed appears willing to look through the soft inflation data, sticking with the view that inflation will move back towards 2%, supported by a tight labor market and a Philips curve model for inflation. Another factor that could jeopardize a September hike is the debt ceiling; I expect that raising the debt ceiling will come down to the wire and will not be resolved before the August recess.

Along with the June statement, the Fed released an addendum outlining the plan for shrinking its balance sheet, which at $4.5 trillion is about $3.6 trillion larger than it was before the financial crisis. The Fed currently owns about $2.5 trillion in Treasuries and $1.8 trillion in mortgage-backed securities (MBS). The Fed plans to gradually decrease its reinvestment of the principal payments it receives from these securities. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. For Treasuries, the cap will start at $6 billion, and rise quarterly till it hits $30 billion. For MBS, the cap will start at $4 billion and rise quarterly till it hits $20 billion.

The Fed will likely approach shrinking its balance sheet very carefully to avoid a repeat of the 2013 sell-off in the bond market following then Fed Chair Ben Bernanke’s comments about tapering the Fed’s bond-buying program.

Q: How do you think the markets will react to the Fed’s efforts to reduce its balance sheet?

IRVING: I don’t know how the market is going to react. The Fed hasn’t used this tool to tighten monetary policy before, so there are unknowns. But I think there are reasons not to be too worried about the balance sheet reduction. First, the Fed will shrink the balance sheet much more slowly than it grew it through its bond-buying program. Second, I think some of the effects of balance sheet normalization may already be priced into the bond market, as rates have risen and mortgage spreads have widened. Finally, I think the Fed may adopt an easier path for the federal funds rate. They may be able to raise short-term rates less than they otherwise would because now they have this second dial to tighten monetary policy.

Q: Where are you seeing opportunities in the bond market?

IRVING: Treasury inflation-protected securities (TIPS) look modestly cheap relative to conventional Treasuries. TIPS have underperformed in recent months, and have given back much of the gains they had between the November election and the Fed’s December rate hike. The market now appears to be recalibrating its expectations for tax and spending policies from Washington.

Mortgage-backed securities (MBS) still look expensive and several factors could cause these bonds to underperform. For example, they tend to suffer when investors anticipate higher volatility in interest rates, because that increases the risk that investors will prepay their mortgages. What’s more, the Fed’s bond sales may pose more of a challenge for the mortgage market than the Treasury market, because it will be more difficult for the mortgage market to absorb them.

Yield spreads are relatively tight for corporate bonds, high-yield bonds, and mortgage-backed securities. Meanwhile, implied volatility is near its lowest level in 25 years, as measured by the MOVE index, which tracks volatility in one-month options on Treasury futures. That’s remarkable. In an environment when yield spreads are tight and volatility is low, investors may want to consider reducing risk.

Q: Should investors worry about rising rates?

IRVING: I don’t think investors should shun bonds just because we’re in a rising rate environment. Fed rates most directly affect yields on shorter-maturity bonds, and I don’t expect yields on longer maturity bonds to rise in the same way or to the same degree. The yield curve is pricing in a very slow pace of rate hikes, with a 50% chance of one more hike this year, and a total of three more hikes this cycle. That seems about right to me.

In general, investors should avoid the temptation to trade tactically in and out of the bond market, and instead take a steady and balanced approach to asset allocation. I believe that approach is more likely to generate favorable long-term outcomes.

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