By Henry Ma, Julex Capital Management During her recent speech before the Greater Providence Chamber of Commerce, US Federal Reserve Chair Janet Yellen indicated the Fed may raise rates at some point this year. As she put it:
” … if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.”
With the rate hike in the horizon, investors may wonder what will happen to their bond portfolio. If you are a student of history, you may find the past experience a useful guide here.
Impact on Bonds
Figure 1 (below) plots the interest rates, inflation and unemployment rate since 1990. The rate hikes in 1994 and 2004 both started when the unemployment rate was around 5-6% and kept dropping. The current unemployment rate stands at 5.4%. Even though the inflation threat is less of a problem than that in the last two rate hikes, it is totally justified that the Fed can start tightening soon as the job market continues to improve.
Source: Julex Capital Management
In the dramatic rate hike of 1994, the Fed raised fed funds rate by 300 basis points over the course of one year. As a result, the ten-year Treasury rate rose by 200 basis points (bps) and Barclays Aggregate Bond Index dropped by 2.24% However, in the rate hike of 2004, the Fed adopted a more orderly and slower approach. It took two years and 25 basis point rate-increase every meeting to raise the Fed funds rate by 425 basis points.