What Happens When FedTrade Ends?

Wednesday, February 22, 2017

Today, federal funds futures markets imply that two rate hikes will occur during 2017, the first in June. All things considered, we believe predictions of two to three rate hikes from 2017 through early 2018 are reasonable.

Regardless, we are finally off the zero-interest-rate path, so there are returns to be earned by fixed-income investors. Three-month LIBOR increased to more than 1.00% in January 2017. This means investors are being compensated by short-term investments. In this piece, we discuss which securities look attractive.

Perhaps more importantly, we explain how the Fed continues to purchase agency mortgage-backed securities on a daily basis, which helps keep mortgage rates low, thereby promoting homeownership and home-price appreciation. The big question is what will happen when this so-called FedTrade ends. There is a rich debate occurring about whether the Fed will need to sell securities from its balance sheet, and any decision to sell securities—or even a market expectation that the Fed will sell securities—could result in more broad-based volatility.

Finally, we review a key market metric we following to gauge some of these risks: the Bank of America/Merrill Lynch MOVE Index, which measures implied volatility of U.S. Treasury rates across the yield curve.

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