The Fed Declined to Raise Interest Rates. Now What?

September 21, 2015

The Federal Reserve’s decision to not raise interest rates in September has left many in the fixed income market unsure of how to react. Baird sat down with Craig Elder, Senior Fixed Income Research Analyst and author of Baird’s Fixed Income Market Commentary, for insight into why the Fed left rates unchanged and how its decision could impact the bond market going forward.

Baird: The Fed announced on Thursday that they’re leaving rates near zero, where they’ve been since the onset of the financial crisis. Why are they holding off?

Craig: I think there are a couple of reasons. For one, when you raise rates, the dollar gets stronger, and there’s concern that a strong dollar will have a negative effect on U.S. economic growth longer-term. In her conference call, Fed Chairwoman Janet Yellen also mentioned they’re continuing to monitor slack in the labor markets, especially in the underemployment rate (the BLS U-6 measure), which provides a more comprehensive view of the labor market than does the unemployment rate (the BLS U-3 measure).

As we’ve discussed before, wage-driven inflation will partly determine when the Fed decides to raise rates. With inflation currently weaker than expected, the Fed believes they have more time to act than they previously thought.

Baird: Is the decision not to raise rates an indication the U.S. economy is still struggling to find its footing?

Craig: Actually, in their press release after the meeting, the Fed painted what seems to be an optimistic picture of the economy, citing improvements in economic activity, household spending, business investment and the labor market. I think their decision is more a reflection on what's happening globally, and the fact that they're not feeling pressured to act.

Baird: Do you still feel they’ll raise rates this year?

Craig: We believe they’ll raise them in October or December. But remember, we think inflation will come back eventually. If you wait until March and you start seeing inflation numbers moving higher, that could force the Fed to raise rates at a quicker pace than they might like, either more interest rate moves or larger moves – 50 basis points instead of 25 basis points.

Baird: What effect would that have on the markets?

Craig: The way I look at rates, everything is based off the yield curve, starting with the Fed Funds target rate. Let's say we get 1% on the Fed Funds target. To get out to the two-year yield, we need another 50 basis points, so we’re at 1.5% on the two-year Treasury note yield. To get to the 10-year yield, we should add 100 –125 basis points – what I would call a normal 2–10 spread – to put us to 2.5–2.75%. Add another 50 basis points to get us to the 30-year bond yield of 3–3.25%. We do not believe this scenario puts excessive pressure on the economy from higher interest rates.

However, if inflation rises more than the Fed anticipates, the scenario in which the Fed funds goes to 2% in 2016 could result in the 10-year yield of 3.5–3.75%. Those higher interest rates would put pressure on economic growth.

They've got to move much more quickly, they've got to have more moves, or they have to make larger, 50-basis-point moves in this scenario. That could be a shock to the system. It'd be tough on the equity markets and obviously it's not going to be good for the bond markets, especially on the short end of the yield curve.

That’s why if you pin me down, I would not be surprised if we had 25-basis-point increase in October.

Baird: How do you expect today’s announcement to play out in the bond market?

Craig: You have to remember that the impact of Fed is felt most acutely on the short end of the curve. So while the yield on the 10-year bond is up, on the two-year it's really fallen, going from 80 basis points down to 68 basis points. That's a big move that caused a monster rally. I mean, if this were the equity markets, they'd be running breaking news bulletins on all the major media. But I think it’s temporary – I didn't see anything in the press conference that made me think, “Okay, they're just going to be on hold and stay in this zero-range bound forever.”

Baird: We talked about the bond market – what advice do you have for the fixed-income investor trying to absorb today’s announcement?

Craig: I think if you're in a high tax bracket, you've got to look at municipal bonds and you ladder your portfolio. If you're looking for yield, we prefer preferred stock that have fixed to floating-rate coupons. For the more conservative investor, consider looking for step-up agencies, which have gapped out to where they’re trading 60 basis points wide of the Treasury. But generally, I’d say do your asset allocation, and don't worry about short-term moves. Rates are eventually going to go back up – it may be this year, it may be next year, but the Fed will start raising rates on the short end. But for now, we wait until October.