Caution: Paying too much attention to Fed watchers can be injurious to your long-term financial health. Maybe, instead of watching the Fed watchers, we should be watching what the Fed is watching.
Since Fed Chairman Alan Greenspan hinted the Fed might begin to push up short-term interest rates, Wall Street prophets of doom have once again declared the end of the long- running bull market in bonds. The investing public has been bludgeoned by forecasts of extraordinarily higher interest rates, while pundits are relentlessly comparing the current economic conditions to those of 1994, when Fed rate hikes precipitated a huge bond market sell-off.
The Federal Open Market Committee (FOMC) altered its policy statement to reflect its belief that short-term rates may have to be nudged up for the economic recovery to remain on solid footing. Interestingly, the FOMC decided to leave its benchmark Fed funds rate unchanged, despite the fact that various Fed governors have remarked that this rate is currently set at an “abnormally” low level.
Not 1994
The media’s constant references to 1994 sent us back to the archives to see if we could identify any parallels to today’s economic environment and current market conditions. Our research revealed some distinct and important differences.
In 1994, Treasury bond traders were caught by surprise when the Fed made its first tightening move. Ten years later, they decided to take matters into their own hands. Since April 1, yields on two-year and five-year Treasury notes have jumped by more than 100 basis points (one full percentage point), while at the same time, 10- and 30-year bond yields have risen to approximately 4.80% and 5.50% from 3.68% and 4.64%, respectively, in the last two months.
This pre-emptive action by the bond market, in itself, precludes 2004 from resembling 1994. In 1994, there was virtually no movement in bond yields in the months leading up to the Fed’s first rate hike. It is obvious to us that the market has already discounted a number of Fed tightening moves.
It is curious that while the media is obsessing over the fact that interest rates may be rising, it generally overlooks the fact that they already have.
Ironically, in 1994 rates rose due to fear of inflation, which never materialized. Today, the inflation hawks are again out in force even though core consumer prices have risen only 1.6% over the past 12 months and, during the same period, productivity has increased by 3.5%, keeping a lid on labor costs.
Good time for disciplined investors
Once again, what the “experts” are missing is that 1994 was a great year for municipal bond investors who maintained their discipline by buying bonds when their investment dollars were available, rather than allowing themselves to be scared into retreating to the money market while trying to anticipate interest rate movements.
Disciplined investors took advantage of the higher yields on tax-free bonds before interest rates resumed their decline. We think a similar opportunity exists now.
Today, AAA municipal bonds can be purchased to yield over 5% tax-free. This is comparable to 7.69% for an investor in the maximum tax bracket.
Though the Fed recently decided to take no action on rates, we think that by the time they do, long-term rates will have already peaked.