Markets react to the Economic Policy Symposium
The federal funds rate is the main tool that sets the U.S. Federal Reserve’s policy. The federal funds rate has been at unprecedented levels of 0.0%-0.25% since December 2008. The Fed maintained a highly accommodative monetary policy stance to bring the economy out of the worst recession since the 1930s. There have been recent economic improvements. Markets are waiting for the Fed to announce the first rate hike in nearly six years.
Fed Chair Janet Yellen spoke at the Kansas City Fed’s Economic Policy Symposium in Jackson Hole. She indicated that rate hikes could come in faster than the Fed expected if inflation and unemployment reach their goals sooner.
In 2014, the labor market recovery has surprised markets on the upside. Labor market recovery and the slight shift in Janet Yellen’s dovish stance (refer to the previous section) have caused market reactions. This implies that faster rate hikes are likely.
An increase in rates would be negative for stock and bond markets. Companies would face higher borrowing costs. This would affect their bottom-line as interest expense increases. Higher borrowing costs could restrict the use of leverage in their financing structure. This would affect returns to shareholders.
Bond markets are directly impacted by higher rates. An increase in the federal funds rate translates across all quality and maturity bonds. Bond prices (TLT) and yields move in opposite directions. As a result, most bond returns would be impacted. However, inverse bond exchange-traded funds (or ETFs), like the ProShares UltraShort 20+ Year Treasury (TBT), would benefit. Floating rate debt would also benefit. Floating rate debt’s interest is indexed to market rates.
Intermediate-term Treasury yields between two years and seven years increased on August 22. Two-year and five-year yields increased the most—a day-over-day gain of four basis points.
However, longer-term Treasury yields, between ten years and 30 years declined. 30-year Treasury (TLT) yields declined the most by three basis points.
Shorter maturity Treasuries are more sensitive to future interest rate changes. In contrast, longer-dated debt is driven by other factors including long-term growth prospects, overseas demand, and inflation expectations.
For more information on factors that drive the demand for U.S. Treasuries, read the Market Realist series, Why the Fed’s policy remains the key driver for US Treasuries.