Volatility to Rise in 2015, But Not Because the Fed Raises Interest Rates

Last week the Federal Reserve’s Federal Open Market Committee (FOMC) released the minutes from its previous policy meeting. These minutes provide an inside look at the discussion that ultimately results in the decision whether or not to change the policy target, which has been stuck at zero percent since late 2008. Goldman Sachs economists noted that though the minutes contained "few surprises," there were a handful of noteworthy changes. "Several" discussion participants supported raising the policy target in June, while "others" favored waiting until later in 2015. Committee members m cited low inflation, dragged down by slumping energy prices and a stronger dollar, as a reason for waiting to raise interest rates. This is interesting because several participants stated, outside of the policy discussion, that oil and a strong dollar were "transitory" (see Evans, Lacker, and Fischer). These participants noted weaker growth on lower consumer spending, residential investment and net exports, and also cited slow wage improvement. On balance, the minutes told the market little it did not already know. Goldman pointed out in a related research report that the FOMC meeting minutes from the past fifteen years tend to produce a two basis point impact on 10-year Treasury bond yields in the thirty minutes following the release, which is incorporated into bond prices "virtually instantaneously" (for comparison, the official FOMC statement has an impact of roughly double that, around four basis points). The minutes confirm the widely held suspicion that the FOMC will raise interest rates sometime over the next twelve months, but that the timing remains uncertain. Despite the Fed’s effort to project their intentions, some of the biggest bond money managers still see reason for additional market volatility. BlackRock last month wrote that the dip in market volatility in mid-2014 was "nice while it lasted," but that the bumpy start to 2015 "suggests a volatile year to come." PIMCO said the same thing, essentially: "We expect ‘Yellenomics’ to lose its grip on market prices…leading to an increase in market volatility." We agree that there will be additional volatility, but for different reasons. The market, in our view, has already priced in an interest rate increase. We remain cautious, however, because domestic fundamentals, specifically economic growth, job creation and inflation, the driving forces behind the rising rate argument, all appear to be flagging. That said, our portfolio durations are modestly overweight, both to reflect our cautious economic outlook and also to capture incremental daily accrued interest.

Sources: FRB, GS, Bloomberg, BlackRock, PIMCO, SNWAM Research