The Federal Reserve’s years-long zero-interest rate policy has flattened Treasury yields to where rising interest rates and inflation are almost assured manifestations, according to Pioneer Investments’ latest blue paper, “The Danger of Duration With a Monetary Policy Change”, written by Michael Temple, Senior VP and Director of Credit Research. In this scenario, “investors may have to face the threat of rising bond yields with periods of significant volatility”.
The Key Points for this Blue Paper are:
- “The Great Monetary Experiment,” the Federal Reserve’s zero rate policy, may be coming to an end. But many investors may be being lulled into a potential false sense of security that rising rates are a long way off. The Fed not only expects the yield curve to steepen, but may in fact encourage it. This could be a wakeup call.
- The U.S. economy may likely surprise to the upside shortly, driven by multiple secular forces including a resurgence in home prices and home construction, an energy renaissance, and a revival of credit demand.
- This would propel a normalization of the yield curve and many scenarios could emerge. With the Fed Funds rate anchored at zero, the sequencing and speed of monetary accommodation removal could have consequences as to how fast the yield curve adjusts.
- The fear of an imprecise course correction is palpable among many investors and economic pundits. There is a growing fear that the Fed may commit to zero far longer than economically necessary. The consequence could be an escape from Treasuries by retail, institutional and foreign investors.
- Investors need to be aware of the potential consequences to their fixed income investments as this paradigm shift takes place. The blue paper explores the math of duration, which is particularly dangerous in this historically low yield environment. However, not all duration is bad. Indeed, spread duration has the ability not only to help cushion the loss but also provide strong and positive excess returns in a rising yield-curve and interest-rate environment.
- As financial markets grapple with the coming structural change in the yield and interest rate environment, high-quality, fixed-income bonds will likely experience periods of significant volatility. The transition to a new investment paradigm is rarely smooth.
- Finally, the report takes a look at the fixed income subsectors that are being viewed as “refuges” from what may be a turbulent transition to higher rates.
You may access the complete report through this link.