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.

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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.

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