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February 21, 2017

The Fed is on Course to Raise Rates, Reminiscent of 2016

Federal Reserve Chair Janet Yellen indicated that if the Fed waits too long to raise rates, it would be an “unwise”. If economic growth and inflation continues to rise, the Federal Reserve would be forced to raise rates. Yellenstated
"Waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession”

Now, this is reminiscent of last year when the Fed indicated it would raise rates multiple times, but only raised rates once in its December 2016 meeting. Prior to that, the Federal hiked interest rates in December 2015. However, the it’s still the same idea now, as it was the past two years. We simply do not know what the Federal Reserve will do until it actually decides to raise rates. There was strong economic data last year, but the Federal Reserve was more concerned about adding volatility to the markets, rather than doing what was in line with its comments.

Yellen’s Comments Affected U.S. Treasuries

Fed Chair Yellen indicated to the U.S. Senate Banking Committee that the central bank expects inflation to rise. Consequently, Federal Reserve voting members could vote for a rate hike. Yellen also stated, 
At our upcoming meetings, the committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate."

According to trader Jason Bond
“Yellen’s comments weighed on some ETFs after her speech and comments were released. The iShares Barclays 20+ Year Treasury Bond Fund (NASDAQ: TLT) saw some volatility and ended the day down 0.72%, on February 14, 2017. Now, there could be heightened volatility heading into the next meeting, but it’s a wait and see game with the Fed.”

With that in mind, markets placed a higher percentage of a Fed rate hike after these comments. 
However, based on the CME Group 30-Day Fed Fund futures prices, the projected probability of a rate hike in March 2017 is still relatively low. Here’s a look at the FedWatch Tool below:

According to the FedWatch Tool, the CME Group 30-Day Fed Fund futures prices indicated that the market is placing at 31% probability of a rate hike in the next Fed meeting.

Don’t Shy Away From U.S. Treasuries Just Yet

After Yellen’s testimony, U.S. Treasury yields climbed higher, which caused U.S. Treasury securities to fall. U.S. Treasury ETFs, such as TLT, the iShares 3-7 Year Treasury Bond ETF (NYSEARCA: IEI) and iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF) all fell across the board due to the potential rise in rates, on February 14, 2017. Although this may be bad for U.S. Treasuries in the short run, these ETFs tracking U.S. Treasury securities could offer more attractive yields in the long run, which could cause some investors to get involved on the long side.

“…most importantly for your bond ETFs, know that rising interest rates may actually be good for long-term investors…When interest rates rise, the price of your fund at first drops. But then the fund begins to reinvest cash flows at the new higher yields, which would steadily boost income. Over time, this increased income can potentially offset the initial price decline.”

The Bottom Line

Although Yellen indicated that the Fed is open to raising rates in March, it could be a good thing for bonds in the long run. Despite the inverse relationship between bonds and interest rates, funds investing in bonds reinvest cash flows at higher interest rates, which would increase income over time. With the in mind, some U.S. Treasury bond ETFs that investors may want to keep an eye on are TLT, IEI and IEF.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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Item Reviewed: The Fed is on Course to Raise Rates, Reminiscent of 2016 Rating: 5 Reviewed By: EconMatters