In recent research released by the Federal Reserve Bank of San Francisco and echoed in statements by several Fed regional bank presidents, Fed officials have voiced concerns that the market is underestimating the probability and timing of a change in monetary policy.1 If previous market cycles are any indication, heavy positioning and an earlier-than-anticipated tightening cycle by the Fed could leave many investors vulnerable to a shift in policy.

In today’s market, two- year Treasury yields are anchored near 0.50%.2 We believe it is possible that yields could breach 1% for the first time in nearly five years in anticipation of the first Fed rate hike. Absent other factors, this could result in a loss in price terms from current levels of approximately 1%. While not a devastating loss, it does significantly raise the prospect of negative total returns in this part of the yield curve given the current low levels of income potential.

As we explore below, from a timing perspective, Morgan Stanley has determined that during the most recent tightening cycle of 2003–2004, markets began to price in a change in Fed policy approximately six months before the actual change.3 With current forecasters calling for the first rate hike in mid-2015, we believe that now may be a prudent time to reduce interest rate risk in anticipation of this shift in policy.

Yields and Total Returns of 2-Yr Treasury Notes during Past Tightening Periods- Yield and Rate Levels

For definitions of terms and Indexes in the chart, visit our glossary.

While today’s path to tightening is in many ways unprecedented, we believe looking at past tightening periods can provide valuable insight into the possible future path of rates. The most significant difference between today’s markets and past periods is the initial level of interest rates. In each of the three previous tightening periods, much higher yields provided a sizable cushion to offset losses related to lower bond prices as interest rates rose. For example, two-year Treasury yields rose by 103 basis points (bps) in the six months preceding the first Fed rate hike in 2003. In 1998, rates rose by 102 basis points.4 However, in both instances, total returns remained positive given the higher starting levels of yields. While it is noteworthy that rates rose by approximately the same amount in the six months preceding the first rate hike during the previous two cycles, we do not believe this will necessarily occur in 2015. This view is primarily driven by our outlook not only for the timing of the first rate hike, but the pace of subsequent hikes and the ultimate “neutral” policy rate.