Interest Rate Hikes – What To Look For From The Fed

Interest Rate Hikes – What To Look For From The Fed

Interest Rate Hikes – What To Look For From The Fed by Matthew Tucker, CFA – BlackRock

With most market participants expecting a hold on interest rates at the Fed’s April meeting, Matt Tucker looks beyond the rate-hike decision in this post.

Once again it is time for the U.S. Federal Reserve (Fed) Board of Governors meeting, and the market is eager to see what they have to say. There is broad expectation that the Fed will hold short-term interest rates steady on Wednesday. With no rate change expected, the market’s focus has shifted to how the Fed talks about its economic outlook and what clues it gives about what it might do at the upcoming meetings in June and beyond. The Fed fund futures market isn’t pricing in a Fed interest rate hike until November, and for that timetable to move up, we will have to see more optimism in the Fed’s communications.

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One way to gauge how confident investors are feeling about the Fed and markets is to look at exchange-traded fund (ETF) flows. Released every day, these data provide an up-to-date view on how a variety of investors (from individuals to institutions) are positioning themselves in the current market. This makes ETF flows a valuable tool for gauging overall market sentiment.

Since the last Fed meeting on March 16, we have seen strong interest in bond ETFs, with $4.8 billion coming into the category, according to Bloomberg data. So people are allocating to fixed income, but why? A closer look at where in the bond market people are putting their money provides some hints:

Every category in fixed income is positive… except for one

As you can see, investors have been moving to the riskier parts of the market that offer higher potential yield, such as emerging markets, high yield and investment grade bonds. They have also been turning to broad fixed income funds (see the chart above) that contain many of these same sectors. The overall message is clear: investors are willing to take more risks in their fixed income portfolios. This could be a sign that investors are feeling bullish about the economy going forward.

Investors have been putting money in Treasury Inflation Protected Securities (TIPS). These are bond issues by the U.S. Treasury that compensate the holder for a rise in inflation. This allocation would suggest that investors believe inflation may be on the rise and is going to break out of the low levels that we have seen these past few years.

So where is all of this money coming from?

It is pretty clear; it is coming out of nominal Treasuries. Nominal Treasuries, different from TIPS, are the securities that people generally think of first when you say Treasuries. Most of them pay a fixed semiannual coupon, and an investor receives their par back when the bonds mature at a set date in the future. Generally the highest quality and lowest yield security in the market, investors flock to nominal Treasuries when they are concerned about the outlook for the economy or about riskier sectors such as equities or high yield debt. The flows out of nominal Treasuries suggest that investors feel less of a need for safety, which is supported by the flows we see in other sectors.

Interest rate hikes – So what is the Fed going to do on Wednesday?

We think short-term interest rates will stay where they are. The Fed is likely to note that the improvement in market sentiment contrasts with what they view as the balance of factors that could help or hinder growth in the future. All in all, we don’t think it’ll be a very illuminating Fed meeting. The key things to focus on will be the clues that the Fed drops on future interest rate hikes, and the direction of money flows we see with fixed income ETFs over the coming months.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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