While the Federal Reserve (Fed)’s announcement last week of further tapering was widely expected, investors were temporarily taken aback – at least for a day – by the prospect of an earlier-than-expected rate hike.
New Fed Chair Janet Yellen’s comment that the Fed could hike short-term rates six-months following the end of quantitative easing (QE) came as a surprise. If the Fed follows through, and continues its current pace of tapering, this could mean rate hikes in the spring of 2015, earlier than the markets had previously forecasted.
The notion that interest rates might rise somewhat earlier than expected was also reinforced by more optimistic economic projections from Fed members.
While the path of future rates is still data dependent, and it’s not yet entirely clear whether the market interpreted the Fed correctly, the possibility of higher rates does have three implications for investors, as I write in my new weekly commentary.
A stronger dollar. Higher U.S. rates – particularly at a time when Japan continues to aggressively ease monetary policy and the European Central Bank may be forced to also ease given persistent deflationary pressure – suggest a stronger dollar (which rallied sharply last week).
More volatility in short to intermediate duration bonds. As I’ve been discussing for most of the year, short and intermediate duration Treasury bonds – those in the three- to seven-year vicinity – are most susceptible to an early rate hike. As such, investors may find that this part of the curve experiences the most volatility in coming months.