Sorry to be dramatic, but it is true. There is a huge disconnect between what the Federal Reserve is saying it is going to do with short-term interest rates and what the bond market has priced in. The chart below from Bloomberg compares the path of interest rates based on Fed funds futures contracts and the median estimate of rates from the Fed’s policy setting committee.
Based on the Fed’s latest projections, short-term interest rates are expected to be at 1.375% by the end of next year and 2.625% by the end of 2017. Sixteen out of the 17 FOMC participants project interest rates of 0.75% or higher by the end of next year. Only a single policymaker (the kooky Mr. Kocherlakota) who will step down at the end of this year projects anything less.
The bond market isn’t buying the Fed’s projections though. And why would they? The Fed has continually moved the goal posts on investors to justify subsidizing Wall Street at the expense of Main Street. They did it again in September. After hyping up an interest rate increase for months, the Fed couldn’t bring itself to pull the trigger. They justified their decision to hold off yet again by citing stock market volatility (ah the Yellen-put) and international developments (that’s a new one).
The problem for income investors is that if the Fed ever makes good on its promises to hike interest rates, the bond market is likely to sell off sharply. If you invest in long maturity bonds (because, let’s face it, the Fed’s zero percent interest rate policy has left you few alternatives) you risk taking it in the neck if the market moves in the direction of the Fed. If the reckoning comes in the form of the Fed submitting to the market’s will, well then, you will have collected a few extra dollars in interest income. In one scenario you lose a bundle and in the other you make a few bucks. That doesn’t sound like a favorable risk reward.
Stay short and stay patient is the prudent advice today.