The Fed met again April 30-May 1 and as expected, kept interest rate policy unchanged. But the recent debate at the Fed has focused less on interest rates and more on when to begin reducing its bond purchases from the current pace of $85 billion per month. A few Fed members have indicated that they would like to taper down purchases later this year. What does that mean for the bond market?
A steeper yield curve is likely.
When the Fed signals a slowdown in bond purchases it could trigger
higher long-term interest rates and a steepening yield curve, in our
view. Since the Fed has concentrated its bond buying in long-term debt,
less buying would mean that private sector buyers would need to step in
to fill the gap. It's likely they would demand higher interest rates
than the Fed. Also, presumably the Fed will begin tapering its purchases
when they are confident that the economy is a on a sustainable path to
stronger growth and lower unemployment. Those factors are likely to push
long-term interest rates higher as well. However, based on the latest
projections by the Fed, most members see short-term interest rates to
remain near zero until 2016. Consequently, we anticipate that the yield
curve will steepen with short-term rates remaining anchored at low
levels while long-term interest rates move higher.
Bottom line. The Fed could begin to signal that they are going to
reduce the pace of monthly bond purchases later this year. We would
expect that long-term interest rates are likely to move higher and the
yield curve to steepen, in response to that signal. Although we don't
expect a sharp rise in interest rates, we suggest preparing for a
steeper yield curve by limiting your exposure to long-term bonds.