- The timing of the Fed’s QE exit is no longer the central question
- An accelerating economy could mean another challenging year for duration risk
- A major question is whether markets begin to doubt the Fed’s commitment to low rates
If bond investors were asked to summarize 2013 in a single word, we suspect that many would pick “taper.” The question of when the Federal Reserve (the Fed) would begin dialing back quantitative easing (QE) dominated market debates from the first taper hint in January until officials finally announced the change at their December meeting. With the process now in train and expected to continue at a steady pace throughout this year, the timing of the Fed’s QE exit is no longer the central question in the interest rate outlook. Instead, at the start of 2014, market attention is now turning toward growth.
Unlike most asset classes, government bonds and other interest rate-sensitive securities tend to perform best when the economy performs poorly—when growth and inflation are falling and the Federal Reserve eases monetary policy. Exhibit 1 shows this relationship using returns over the last three decades. Treasuries show up in the lower left corner, meaning that their returns are negatively correlated with growth and inflation surprises. In other words, Treasury returns increase when growth and/or inflation fall. The combination of subpar growth, weak inflation and aggressive central bank easing led to solid total returns for Treasuries in 2008 through 2012.
Exhibit 1: Excess returns vs. growth and inflation expectations (%)
Source: Columbia Management Investment Advisers, LLC. Note: *t-statistics of returns (excess returns for fixed income) on changes in growth and inflation expectations; sample 1989-2012; shorter for emerging markets (EM) and agency-backed securities (ABS). Past performance does not guarantee future results.
Although interest rate valuation improved a lot over the last year**, an accelerating economy means that 2014 could be another challenging year for duration risk. Indeed, we are already seeing signs that growth is picking up. The Commerce Department reported that real gross domestic product (GDP) increased by 4.1% (annualized) in Q3 2013, and most economists see an increase of about 2.5% in Q4. A second half growth rate of 3.25% would be significantly higher than forecasters expected just a few months ago. Our proprietary measure of U.S. economic growth—which is based on a broader set of data than those used to calculated GDP—also shows growth of more than 3% in recent months. If this brisk pace continues, investors should expect further increases in longer-term interest rates.
At the moment, the yield curve is being anchored down by what Fed officials call their “forward guidance”: their quasi-commitment to keep short-term interest rates near zero until late 2015. A major question for 2014 is whether bond investors begin to doubt the credibility of the Fed’s forward guidance if the unemployment rate falls further and inflation picks up. While we think that a major breakdown of the forward guidance is still unlikely, the issue could be a source of rate market volatility this year.
Overall we think bond investors should plan for another year of low returns from interest rate risk, and a higher and flatter yield curve over time. The improvement in valuations means that the outlook for duration risk is not nearly as worrisome as it was last year. But the healing economy could still be a meaningful headwind, especially if markets begin to doubt the Fed’s commitment to low rates.
**See our white paper The Bond Risk Premium for background on our interest rate valuation framework.