Doing the Twist

The Fed finally hiked rates the other day, after several stomach churning months of speculation. The deliberation was in itself causing volatility and disruption in the markets. So, from that perspective, it’s good to have it behind us.

On the other hand. While short interest rates have already risen to account for this eventuality, now that it’s happened, rates actually fell. The markets behave this way sometimes – in what seems to be a counter intuitive manner. A few factors support this reaction, however. First, the Fed made it clear it would keep its current bond holdings intact. These are the securities it bought to support the economy in the aftermath of the credit crisis. Rather than allowing these to run off, the Fed will continue reinvesting the income from these bonds in new bonds.

Second, it’s pretty late in the economic cycle to be hiking interest rates. The uncertainty about the effects of this late hike caused stocks to sell off, and bond investors to wonder if perhaps this hike will cause unintended consequences that could slow the economy. Investors point to other countries’ central bank hikes over the last couple of years: most were rescinded shortly afterward.

Our expectation was that a hike in the Fed’s overnight rate – which affects short term rates like cash and Treasury bills – would make the long end of the market fall in yield, and rise in price. We expected the yield curve to ‘twist’ around about the ten year area. The few days’ aftermath of the hike have played out this way. From here on out, we need to see more inflation and more growth before we see much higher long term interest rates. That could happen – we can’t count it out; in fact, that’s what the Fed expects. So far, the market is saying otherwise. Six months from now, we’ll probably know who’s going to be right.