Waddell & Reed

Market Perspectives

Mid-year fixed income outlook: Keeping an eye on the Fed’s interest rate elevator

Story Highlights

  • Concerns about the Federal Reserve possibly tapering its bond market activities upended fixed income markets in the spring.
  • Federal Reserve officials have scrambled to clarify some of their comments and clear some of the confusion about their outlook.
  • With inflation pressures remaining muted, an interest rate hike by the Fed continues to remain unlikely.
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Concerns about the potential impact of a rising interest rate environment upended fixed income markets in the spring. With an increasing belief that the Federal Reserve (Fed) was preparing to end its bond-buying program known as quantitative easing (QE), investors bailed from bond mutual funds and exchange traded funds at record clip. Through the first three weeks of June, bond fund outflows topped $47 billion — the highest for any month on record, according to TrimTabs Investment Research — easily exceeding the $41.8 billion record set in October 2008. For the benchmark 10-year Treasury, yields added nearly 100 basis points between May 1, when it was yielding 1.66%, and June 24, when yields broke through 2.66%.

While some of the angst-driven volatility is understandable — the potential end of the long-running bond rally has been a frequent market discussion topic in recent years and an event that could have wide ramifications — we continue to believe that a rising rate environment is not on the immediate horizon.

Low-rate environment

Mark Beischel, global director of fixed income and portfolio manager of the Waddell & Reed Global Bond Fund, says there are numerous factors supporting the view that rates will continue to remain relatively low.

“I am expecting that the remainder of 2013 through 2014 will be another environment of low global growth due to the continuation of the deleveraging process in the U.S. private sector, the fiscal austerity programs in Europe and the U.K., general uncertainty with regard to fiscal policies globally, and the inability of loose monetary policies to stimulate growth,” Beischel said.

Fed Chairman Ben Bernanke told reporters after the June Federal Open Market Committee (FOMC) meeting that eventual rate increases are likely to be gradual and will hinge on what is going on with employment and inflation. He noted that when unemployment reaches the Fed’s 6.5% target, it will not automatically trigger rate hikes, but signal only that it is “appropriate to consider” an increase. Inflation also will factor into the Fed’s decision. Currently, inflation is running well below the Fed’s 2% target, at 0.7% , according to the personal consumption expenditures price index (PCE) that the Fed uses.

Beischel does not expect a jump in inflation anytime soon.

“The economy is growing too slowly with excess capacity in labor and capital markets and private sector lending is moribund. Real wage growth is very weak; so weak that there is no reason for a concern of inflation,” Beischel said. “My expectations for interest rates are that shorter rates — five years and less — should be less volatile. However, longer Treasury rates will be more volatile and subject to market emotions regarding fiscal and monetary policy.”

The “taper” worm

TThe catalyst for this bout of interest rate fear has been the idea that the Fed will begin to taper the $85 billion a month in bond buying it has been doing under QE. Although Bernanke said that the Fed expects to begin reducing its bond purchases later this year with the program concluding next year, that timeline is based on the economy reacting as the Fed projects, and is not set in stone. Nonetheless, the comments spooked the already jittery markets and prompted an unusual number of Fed officials to speak publicly about the central bank’s predicament in the days after the FOMC meeting.

Among the more unusual comments was a statement from Minneapolis Fed President Narayana Kocherlakota calling for the Fed to offer additional and specific guidance about the conditions necessary for tapering bond purchases. Kocherlakota also said the Fed needs to provide additional information about how policy will respond later in the recovery—specifically a period where he expects both unemployment and inflation to be under Fed targets.

Meanwhile, St. Louis Fed President James Bullard issued a statement calling Bernanke’s tapering timetable “inappropriately timed.” Bullard said that Bernanke should have waited until there were “tangible signs” that the economy is strengthening and that inflation is moving back toward its target. Bullard, who has favored an open-end bond buying program with no set purchase amounts or end dates, has said the Fed needs to show more of a commitment to its 2% inflation target amid low inflation readings.

The Fed’s inflation outlook

Muted inflation expectations also are reflected in a Federal Reserve report. According to a mid-June analysis from the Federal Reserve Bank of Cleveland, public inflation expectations are currently 1.55%, which means the public expects annual inflation to remain below 2% on average over the next decade. The analysis is based on a model computed with a wide range of economic and market data.

According to a report released at the June Fed meeting, Fed officials also have lowered their inflation expectations. Currently, FOMC members are projecting PCE to come in between 1.2% and 1.3% for the year — down from a March projection of 1.5% to 1.6% and well below the FOMC’s December 2012 projection for inflation to be in the 1.6% to 1.9% range for 2013. Currently, Fed officials do not expect to reach the 2% inflation target until 2015 at the soonest. Current Fed projections, however, do indicate the central bank expects to achieve its 6.5% unemployment target by year-end 2014 or early 2015.

As for rate hikes, the Fed report showed that 15 of the 19 FOMC members currently do not expect policy firming to begin until 2015 at the soonest and more than half expect the fed funds rate, currently at zero, to be at 1% or lower by year-end 2015. Under its Congressional mandate, the Fed is responsible for both price stability and employment. In recent months, the Fed has seen mixed results in its bid to move toward its dual policy goals.

Past performance is no guarantee of future results. The opinions expressed in this article are those of the Waddell & Reed and its fund managers and analysts, and are not meant to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. Investing in emerging markets may accentuate these risks. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Waddell & Reed Advisors Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

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