The Road to Higher Interest Rates (Jones)

The Road to Higher Interest Rates (Jones)

June 17, 2013
by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

  • With the Fed signaling that the pace of quantitative easing (QE) may slow later this year, it looks likely that interest rates will trend higher over the next few years.
  • We look at the path that rising rates might take and the likely conditions needed to bring bond yields back to where they were before the financial crisis.
  • Plus, we examine some strategies to consider for the road to higher interest rates.

Fixed income investors have been struggling to find attractive yields over the past few years. With short-term Treasury yields near zero and long-term rates held down by the Federal Reserve's (the Fed) QE program, many investors have moved into riskier sectors of the fixed income markets in search of more income. Now that the Fed is signaling a potential end to QE, it may be the beginning of higher Treasury yields, which could help investors who are looking for higher yields but hesitant about taking so much risk. But it's not likely to be a straight or rapid rise in rates in our view. We think the road to higher rates will be a long and winding one, with a few distinct phases.

Phase one: Tapering

The first step on the road to higher interest rates would likely be paring back the Fed's bond-buying policy. We think that this could happen later this year if job growth picks up. The Fed has indicated that a change in policy could come if there was a substantial improvement in the pace of job growth. One Fed governor has said that this means six consecutive months of job gains of 200,000 or more. The recent six-month average is 208,000, so if the current pace continues, then it may mean the Fed begins to exit its QE program later this year—perhaps announcing the shift at the September FOMC meeting.

Buying fewer bonds isn't the same as actually tightening monetary policy. It's a less easy policy. Nonetheless, we believe that just by signaling a shift in policy, longer-term interest rates could start to move higher. Meanwhile, short-term interest rates are likely to remain anchored near zero. As a consequence, the yield curve would steepen with long-term rates rising relative to short-term interest rates.

How high could rates go in the first phase? In the past, 10-year Treasury yields have averaged about 1.6% more than the fed funds rate. Currently, the yield difference is above the long-term average at about 2%. But the yield spread has expanded to as much as 4% at times when the Fed is in the process of raising short-term rates. Based on this history, we think that long-term interest rates have room to move up from current levels in phase one, but will not likely reach 4% or higher until the Fed is actually in a tightening mode.

10-year Treasury yield and effective federal funds rate: 1983-2013

Source: St. Louis Federal Reserve 10-Year Treasury Constant Maturity Rate (GS10), percent, quarterly, not seasonally adjusted and Effective Federal Funds Rate (FEDFUNDS), percent, quarterly, not seasonally adjusted. Data as of Q1 2013.

This first phase could take some time—possibly a year or longer. The Fed's current policy involves buying $85 billion per month in Treasury and agency mortgage-backed securities. Tapering down the pace of purchases is likely to be a gradual process and, based on comments from Fed Chairman Bernanke, will depend on the economic and inflation data.

Phase two: Tightening

In the second phase, we would expect the Fed to raise short-term interest rates steadily over the course of one to two years. Stronger economic growth and higher inflation are likely to be prerequisites for this tightening.

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