Federal Reserve chair Janet Yellen is going out of her way to assure markets that the central bank is in no hurry to alter its easy-money ways – yet the bond market is worried about higher rates. Is there something here for investors to exploit?
Ms. Yellen testified before Congress on Wednesday, saying that she expects economic activity to rebound after growth of just 0.1 per cent in the first quarter. She also said that inflation should rise toward the Fed's target of 2 per cent, suggesting worries of deflation are now fading.
But while the Fed continues to taper its monthly bond purchases at each monetary policy meeting this year, Ms. Yellen remains cautious on any other policy shifts, owing to what she sees as disappointing housing data and a "far from satisfactory" labour market. As my colleague Kevin Carmichael noted, "Ms. Yellen emphasized that even after the asset-purchase program ends, the Fed's benchmark interest rate will remain at zero for a considerable time."
However, strategists at Pavilion Global Markets pointed out in a note to clients that the U.S. bond market has been pricing in a policy mistake from the Fed. That's why the difference between the yield on short-term bonds and long-term bonds – while still considerable – is flattening out. The strategists explain: "Short-term rates are rising as investors understand that the Fed plans to raise rates sooner rather than later. However, longer maturity yields are falling because the market fears that rate hikes will come too soon and will kill the recovery."
But if the Fed doesn't make a policy mistake by, say, raising its key rate too soon and spoiling the economic recovery, then there could be a buying opportunity here for investors – in stocks, bonds and commodities. Pavilion looked at previous periods, since 1973, in which the yield on two-year bonds rose while the yield on 10-year bonds fell over a four-month period. There were 39 periods, and they tended to be good for bonds: "In the 12 months that followed, the Barclay's government bond index total return was up 4.5 per cent on average. What's more, total returns were positive 87 per cent of the time," Pavilion said.
The flattening periods were good for stocks, too; the S&P 500 rose an average of 6.5 per cent. And commodities really shone: The Goldman Sachs Commodities Index rose an average of 13.8 per cent.
"All in all, the market's fear of the initial rate hike is not rational at this point and should be considered a buying opportunity," the strategists concluded.