Why the Fed’s Low Rates Led to Higher Rates

The extended pledge triggered inflation fears, sending long rates up

   

Why the Fed’s Low Rates Led to Higher Rates

“A great truth is a truth whose opposite is also a truth.” – Thomas Mann

Market reaction to Fed announcements is always interesting, particularly when it creates a change in the perception of inflation expectations. Followers of my writings on other sites know that I focus on intermarket analysis, which is an approach that looks at various sectors and asset classes relative to each other to determine if market participants are sending a message, consciously or subconsciously, about future risk-taking through price.

The most important message from an asset allocation standpoint is what the crowd thinks about inflation expectations. Broadly speaking, being “risk-on” in equities means inflation expectations are rising. “Risk-off” is generally characterized by deflation fears, whereby bonds outperform.

Notice I’m not talking about actual inflation, but inflation expectations. Yesterday, the Fed’s announcement in many ways changed a lot of things internally within the market. With the extension of its low-rate pledge to 2014 from 2013 due to low-growth fears, the initial reaction in the long end of the bond market was a substantial rise in price as yields dropped. Investors immediately believed the Fed was signaling deflation.

However, as the day went on, the long bond gave back all intraday gains and closed down as yields rose. Interestingly, Treasury Inflation Protected Securities (TIPs) far outperformed long bonds even though they have a lesser duration. The low-rate pledge combined with the rather explicit target of 2% inflation immediately forced inflation expectations back into the market, sending stocks higher.

One way of clearly seeing this is to look at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSE:TIP) relative to the iShares Barclays 20+ Treasury Bond 20+ Year Treasury Bond ETF (NYSE:TLT). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/TLT.

Chart 300x161 Why the Fed's Low Rates Led to Higher Rates
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The duration of TIP is less than TLT, meaning it should be less sensitive to interest rate moves, right? Notice the far right of the chart. Inflation protection immediately became the go-to place for investors. This of course is due to the Fed’s low-rate pledge.

And yet, that low-rate pledge sent the long end of the yield curve steeper, resulting in interest rates actually rising slightly yesterday.

My point? Investors are now perceiving the Fed’s low rates as reflationary, which in turn would send long-bond yields higher as the inflation premium gets priced back in.

The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized advice. The opinions herein are not personalized recommendations to buy, sell or hold securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/01/fed-interest-rates-inflation-bonds/.

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