This is a fresh reminder that for the near term the Fed and their actions are likely to remain the primary driver of markets, and especially short term interest rates. As we move closer to the first funds hike it is likely that we will see the difference cited above converge. Whether that means the Fed moving more slowly (or more quickly) than they anticipate, or the market expectations backing off is hard to say, but one way or another, we know the market and the Fed will converge. Because that adjustment has the potential to be volatile, and because the shorter end of the yield curve will bear the brunt of any increase in volatility, we remain cautious on 2 to 5 year maturities. Interestingly, the longer end of the yield curve may exhibit relatively lower volatility as the market and the Fed square off. While long-term investors should be aware of the potential for interest rate volatility, they should keep in mind that their returns will ultimately be driven more by coupon income and the reinvestment of that income.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.