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Tapering and Treasury yields: Important takeaways

Part 4
Tapering and Treasury yields: Important takeaways (Part 4 of 4)

Why treasury yields increased on the hint of an interest rate spike

Timing of policy firming

On the expectation of the tapering to finish by the end of the year, about 13 FOMC participants indicated at the first Fed funds rate hike in 2015. The Fed funds rate median forecast for 2015 presented in the March meeting has moved up to 1.00% from 0.75% as per December projections. The FOMC participants also projected that the Fed funds rate median for the end of 2016 would be about 2.25%— an increase of 0.50% from the projections presented in the December meeting. In the long run, the committee expects the Fed funds rate would reach 4.00%.

Treasury YieldsEnlarge Graph

On the likelihood of a rise in the interest rate, Treasury yields across the mid-end and long-end of Treasury curve soared, pulling down the Treasury prices. Yields on intermediate maturity Treasuries including the three-year, five-year, seven-year, and ten-year yields rose the most, due to high sensitivity with shifts in the monetary policy. Yield on the five-year note at 1.71% was up by 16 basis points since the FOMC meeting. The three-year Treasury yield was up by 13 basis points to 0.88%.

The ten-year Treasury, one of the most important market indicators for the change in the interest rates, traded 10 basis point higher from the previous day at 2.77%. The 30-year bond yield was at 3.66%-4 basis point up.

As a reaction to higher yields, the bond prices for the majority of the Treasury ETFs including iShares Barclays 20+ Yearr Treasury Bond (TLT) were down. The iShares Barclays 20+ Year Treasury Bond Fund seeks results that correspond generally to the price and yield performance, before fees and expenses, of the long-term sector of the U.S. Treasury market as defined by the Barclays Capital U.S. 20+ Year Treasury Bond Index.

Impact of increased interest rates

The Fed is cutting back on its monetary stimulus because it thinks that the economy has recovered from its worst financial crisis to a certain extent. Tapering essentially would reduce the excess liquidity that the Fed has been providing to the market since the start of the financial crisis although the process would remain gradual and accommodative. The Fed would constantly assess the economic growth to take measured steps related to tapering in the future.

Other things being constant, as market liquidity would reduce, and the interest rates would increase. This would pull down bond prices, as bond prices and interest rates share inverse relationship. The opposite holds true for the decline in the interest rates. When the market interest rates drop, new bonds may be issued into the market with lower coupon rate than older bonds. This means that the older bonds are worth more and their market so price goes up.

To negate the effect of the interest rate fluctuations, investor may consider holding investment in the PowerShares Senior Loan Portfolio (BKLN) and Pyxis/iBoxx Senior Loan ETF (SNLN) with top holdings in H.J. Heinz Company (HNZ) and Dell International (DELL). Both the ETFs invest in the floating rate fixed income securities, which adjusts with the change in the market rates.

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