Rising interest rates—implications for the Fed

We’ve argued that since COVID-19 struck, we haven’t been playing in fundamentals land; instead, we’re operating in a world defined by central bank financial repression that’s made investors extremely vulnerable to central bank communication—and miscommunication.

The recent spike in nominal yields has created a genuine sense of unease in the financial markets as investors rush to reassess if risk has been priced appropriately. The U.S. Federal Reserve’s (Fed’s) meeting on March 17 has taken on additional significance, as markets turn to the central bank once again for clues on what it might do next. Ultimately, we think there are three critical questions that the Fed needs to address.

1 Is the rise in yields merely a reflection of a better economic outlook?

Our view: Only partly

2 What would trigger a reaction from the Fed?

Our view: Rising nominal yields alone—what we’ve seen so far—aren’t enough of a trigger; substantially more would need to transpire before the Fed will act

3 If the Fed is triggered, what course of action will it take?

Our view: Verbal intervention and forward guidance in the first instance, long before yield curve control (YCC)¹

Understandably, our view will evolve as additional economic data becomes available and interest rates move. At this juncture, we believe that U.S. interest rates had initially moved up for the right reasons—that is, on the back of stronger growth expectations; however, subsequent moves on the 10 year above 1.3% have been more problematic. Crucially, as of this writing, we do not expect the central bank to initiate concrete intervention.

Herein lies a key issue: The rise in rates driven by nonreflation/growth reasons combined with what can be perceived as a feeble Fed response is likely to be the most problematic outcome for risk assets in general and most consistent with a rise in real rates.

Fed options and the likely market response

 

 

Fed options

Market interpretation/likely response

Recent interest-rate movement is a problem—rates are rising for the wrong reasons Recent interest-rate movement isn’t a problem—it merely reflects a stronger growth outlook

Fed responds with concrete intervention (Operation Twist²/YCC)

  • Risk friendly
  • Likely volatility suppression
  • Real rates higher
  • Flatter U.S. yield curve
  • Most bullish equities
  • Shape of the U.S. yield curve will depend on the form of intervention implemented, with YCC being the most aggressive yield curve steepener
Fed doesn’t respond, or is perceived to have responded poorly
  • Bearish risk
  • Both nominal and real interest rates move higher
  • Flatter U.S. yield curve
  • Countercyclical U.S. dollar strength
  • Value opportunity could emerge in yields, particularly within the corporate bond space
  • U.S. real interest rates remain in a reasonable range as market-based expectations of inflation (breakevens) rise

What has driven U.S. interest rates higher in recent weeks?

We’ve identified four main reasons why yields have pushed higher: economic optimism, expectations of an earlier Fed exit, concerns related to the looming expiration of the supplementary leverage ratio (SLR) exemption, and convexity hedging related to mortgage bonds. Note that not all of them are related to the expected reopening of the economy or improving growth outlook. If they were, we’d be far more sanguine about the rise in rates. 

1 Economic optimism

This is sparked by positive news flow relating to improved vaccine distribution and confirmation that the federal government will indeed provide fiscal support to the economy. 

Market impact 

This is likely to have fueled the rise in 10-year U.S. interest rates to 1.3%, led by Treasury Inflation-Protected Securities (TIPS) breakevens. 

2 An earlier Fed exit

In our view, much of the rise in the 10-year U.S. interest rate above the 1.3% level has been driven by higher real yields and not breakevens, which suggests the move has less to do with the market pricing in more inflation and is more of a reflection of investor expectation that the Fed will normalize rates sooner, even if inflation didn’t rise materially above 2%. 

A better-than-expected February non-farm payrolls report also reinforced the market’s belief that the Fed might normalize rates sooner rather than later. In addition, there's a general sense among investors that Fed Chair Jerome Powell didn’t seem too concerned about the impact that rising interest rates had on the equities market when he spoke at a webinar on March 4.³

Market impact

We believe these developments are behind the recent move in the 10-year U.S. interest rate from 1.3% to 1.5%, led by real yields.

3 Threat of the SLR exemption expiring

The SLR exemption, which temporarily allows banks to hold less capital relative to their liabilities, is set to expire on March 31. If this were to happen, banks will have to hold more capital against their holdings of U.S. Treasuries. Put differently, the looming expiration of SLR exemption is disincentivizing banks from buying U.S. Treasuries and simultaneously encouraging speculators to take short positions in these instruments. Crucially, Fed Chair Powell was noncommittal about the extension at the recent congressional hearing,⁴ and several Democrats have asked for the SLR to be cut,⁵ lending credence to concerns that the exemption won't be extended. 

Market impact

These developments are likely to have exacerbated the move in the 10-year U.S. interest rate from 1.5% to 1.6%.

4 Convexity hedging

One of the key distinguishing characteristics of mortgage bonds, which are often held by large investors such as asset managers and banks, is negative convexity. In other words, when interest rates rise, the duration of these securities also goes up.

Since investors tend to have a preference for stable returns and constant duration, those with exposure to mortgage securities typically sell U.S. Treasury durations when rates go up (and vice versa) as a way to manage this risk.

Understandably, the duration for mortgage bonds has risen sharply this year, which could have exacerbated the wave of U.S. Treasury selling, pushing rates higher.

Market impact

It's likely that convexity hedging might have exacerbated the rise in the 10-year U.S. interest rate from 1.5% to 1.6%.

"In view of the intense market reaction we’ve witnessed in recent weeks, it makes sense for the Fed to communicate clearly and leave little room for miscommunication—failure to do so could be costly."

What could prompt the Fed to act?

Although we're seeing signs of trouble brewing in the markets, we don’t believe enough has transpired to spur the Fed into action, particularly in light of recent comments by its officials. However, it’s entirely possible that events could unfold in such a manner that could convince the Fed to change its mind before the March 17 meeting, or even in the next few months. In our view, the Fed is more likely to respond to the bigger economic picture and act in a holistic manner rather than react to a specific trigger. 

Factors to monitor

Potential trigger Has it occurred? What to monitor
The front end of the U.S. yield curve begins to lift It’s beginning to happen U.S. front-end rates currently imply that the first rate hike could take place in Q4 2022 and that interest rates could rise by 60 basis points by Q1 2023. That’s inconsistent with the Fed’s messaging relating to its recently adopted average inflation-targeting mechanism, its focus on employment, and its economic projections, which indicate that rates will only rise in 2024⁶
Financial conditions materially worsen No
  • Equities: Another sell-off, equivalent to at least 10% from current levels, if not more
  • U.S. dollar: Depreciation has halted, but there's no sign of material strength
  • Credit spreads: A significant widening
Inflation expectations materially soften (breakevens at less than 2.0% for an extended period) It’s beginning to happen While break-even inflation rates have softened, they still remain consistent with a 2.0% to 2.5% inflation outlook. As such, the Fed doesn’t need to push inflation expectations higher. Note: Fed buying may be a distorting signal from breakevens; for instance, the Fed already owns nearly 20% of the TIPS markets⁷
Concern the real economy could worsen through indicators such as mortgage rates, consumer spending, and employment It’s beginning to happen Primary mortgage rates have hit 3%—still low by historical standards—which may already be hampering mortgage applications and new home sales; however, there’s limited evidence that the economy is being unreasonably hampered, for now (this typically becomes more observable after a lag). February’s non-farm payrolls⁷ point to growing strength in the jobs market. In our view, a material spike in both mortgage rates and weekly jobless claims, combined with other triggers, could encourage intervention
Smooth functioning of the financial markets  It’s beginning to happen We’re seeing some initial but nonmaterial evidence of a deterioration in liquidity in the U.S. Treasury market

We’re generally expecting that the Fed will lean against near-term interest-rate hikes currently priced into 2022 and 2023 through strengthened forward guidance and intermeeting communication. The central bank could emphasize that rate hikes aren’t on the table while it remains engaged in quantitative easing (QE) and could turn to what we call calendar-based guidance as a way to pin down the front end of the U.S. yield curve.

In addition, the Fed could introduce some form of tinkering at its March 17 meeting, which could include an extension of the SLR exemption (to encourage banks to hold U.S. Treasuries) and, perhaps, introduce a slight increase to the interest it pays to banks on overnight reserves, which will be a technical adjustment in nature. In view of the intense market reaction we’ve witnessed in recent weeks, it makes sense for the Fed to communicate clearly and leave little room for miscommunication—failure to do so could be costly.

1 Yield curve control refers to a monetary policy tool where a central bank explicitly sets a target for a longer-term interest rate and pledges to keep the rate from rising above its target. 2 Operation Twist is one of many policy tools that central banks can adopt when implementing quantitative easing. The policy is aimed at stimulating economic growth by lowering long-term interest rates, which can be achieved when a central bank finances its purchase of long-term bonds (through its bond purchasing program) with proceeds from the sale of its near-term bond holdings. 3 Stock Market Momentum Comeuppance Gets No Sympathy From the Fed,” Bloomberg, March 4, 2021. 4A $50 Billion Unwind Fueled Treasuries’ Rout. It Has Room to Run,” Bloomberg, March 5, 2021. 5 Democratic senators call for tougher capital requirements for US banks,” Financial Times, March 2, 2021. 6 federalreserve.gov, as of March 8, 2021. 7 Macrobond, Bloomberg, as of March 5, 2021.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.


Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.


The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.


This material, intended for the exclusive use by the recipients who are allowed to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.


Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives, is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of a loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.


Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, and is not registered with, any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.


Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by its affiliates under license.

 

532518

Frances Donald

Frances Donald, 

Global Chief Economist and Strategist, Multi-Asset Solutions Team

Manulife Investment Management

Read bio