We do not believe the recent bond market sell-off is the start of a sustained move higher in interest rates.

Bond yields are likely to remain range-bound, but we continue to favor higher yielding segments of the bond market to avoid more interest rate sensitive sectors.

The broad high-quality bond market began 2013 on a sour note, posting its worst weekly performance since March 2012. Optimism over recently passed legislation to narrowly, or temporarily avert, the fiscal cliff boosted economic growth expectations and concerns that the Federal Reserve (Fed) may end bond purchases as soon as mid-2013 both weighed on high-quality bond prices. The yield curve, which measures the yield differential between short- and long-term Treasuries, steepened notably as the bond market priced in prospects for better economic growth. Price declines and a 0.10% to 0.23% increase in intermediate- to long-term Treasury yields had investors asking whether the long-awaited bond bear market had finally arrived. 

We do not believe this is the start of a sustained sell-off and higher interest rates in the bond market. The current episode, if it continues, is more likely to resemble the short-lived pullback of March 2012 and a similar period of weakness in October 2011. A review of last week’s two market drivers—the release of minutes from the December 13, 2012 Fed meeting and the fiscal cliff deal—help explain why.

The Fed
Market attention appeared to focus on the following few sentences of the Fed’s 25-page FOMC minutes release:

“…a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases. Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.”

That the Fed may end bond purchases sometime in 2013 should not surprise investors. Prior purchase programs, such as QE1, QE2, and Operation Twist contained elements that varied in length from six months to just over one year. At some point, the Fed will have to slow or end bond purchases. Most importantly, Treasury yields actually declined following the end of prior Fed purchases programs, as investors believed the markets were not strong enough to stand on their own [Figure 1]. A slowing or end to bond purchases does not necessarily translate to a rise in bond yields.

Furthermore, Fed Chairman Ben Bernanke and his dovish companions continue to dominate the Fed. A look at the composition of the 2013 incoming Fed policy voters reveals that the majority is dovish, or inclined to keep policy accommodative, including higher ranking members such as Vice Chair Janet Yellen and New York Fed President William Dudley whom together with Bernanke we consider to be the “center of gravity” among Fed decision makers. Easy Fed policy can bode well for higher yielding segments of the bond market, such as corporate debt, as corporations have used lower interest rates to refinance higher interest debt to help keep overall expenses low.

Fiscal Uncertainties Remain
Despite the recent deal to avoid the fiscal cliff, lingering uncertainties in Washington are likely to restrain any rise in bond yields. Financial markets have only a brief reprieve before a new showdown emerges in Washington. The U.S. Treasury reached the debt limit on December 31, 2012 and by late February 2013 will have likely exhausted extraordinary measures to stay under the debt limit. The end of February also marks the date at which postponement of automatic government spending cuts, known as sequestration, will expire. Spending cuts represent a possible further drag on economic growth in addition to recently enacted tax increases—all of which threaten to restrain economic growth and therefore may help keep interest rates low.

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