With the Fed keeping rates unchanged in the September meeting, December is the only possible as well as plausible month for a hike. This is because the next meeting during November 1–2 will be just before the presidential election and the Fed is unlikely to hike rates in an uncertain time like that.
So, if the Fed does not make it in December, economic conditions will be called too soft to afford even a single 25-basis point hike in 2016 after a liftoff in December 2015. And the Fed’s credibility in assessing the economic condition will also come under question.
As per data from CME Group, the probability of a hike in the final month of this year increased to 59% following the Fed comments from 57% prior to the statements (read: Fed Plays Safe As Expected, Outlook Positive: ETFs to Buy).
While several asset classes will be impacted in the medium term, one of the most vulnerable areas will be the U.S. Treasury market which has surged this year with iShares 20+ Year Treasury Bond (TLT - Free Report) gaining about 17% (as of September 27, 2016) (see all Government Bond ETFs here).
Let’s take a look at the Fed’s economic projection and see how the inflation and interest rate backdrop is likely to evolve.
Inside Fed Projections
Notably, policy makers now envisage two rate hikes in 2017, down from the June median projection of three, as per Bloomberg. The Fed still expects three rate hikes in 2018 and three more in 2019.
But at the same time, it cut its long-run target for fed funds to 2.9% from 3%, which is expected to be touched in 2020, at the earliest. This is because Fed funds rate is expected to be 2.6% in 2019. Investors should note that Fed officials reduced GDP growth projection for this year to 1.8% from 2% projected in June, but maintained the PCE inflation projection at 2%.
How Is U.S. Treasury Yield Curve Behaving Post Fed?
The difference in yield between two-year U.S. Treasuries and 30-year U.S. Treasuries declined after the Fed kept interest rates unchanged in the 0.25–0.50% band during the September 20–21 meeting. The yield on two-year U.S. Treasury bonds dropped 4 bps to 0.75% in the last five days (as of September 27, 2016) while the yield on 30-year Treasury bonds declined 11 bps to 2.28% during the same timeframe.
Argument in Favor of Potential Rally in U.S. Treasury
Since long-term yields projections have been cut, investors can play the long-term Treasury bond ETFs at the current level. Also, the Fed has probably held the idea of tightening off till December as the November meeting will happen right before the presidential election – a highly sensitive time. All these factors speak in favor of Treasury bond ETFs.
Argument Against U.S. Treasury
Then again, overvaluation concerns are rife. Societe Generale SA indicated in July that the ‘fair value’ for the 10-year Treasury yield is 1.95%. This suggests that benchmark U.S. Treasuries yielding 1.56% on September 27 are overvalued. Even Deutsche Bank has indicated that “a 35-year party is over for bond bulls. Not only this, BlackRock Inc. also cautioned about owning Treasuries as the Fed is likely to hike this year (read: Is the Treasury Bond ETF Rally Over?).”
Investors should also note that oil prices are likely to remain steady in the medium term on hopes of an output cut in November. This in turn may bolster the inflationary outlook, which can weigh on Treasury bond ETFs.
At this moment, it is wise to play long-term Treasury bond ETFs until the Fed hike talks resurface and the inflation picture remains muted. Also, a still-edgy market will support safe-haven long-term Treasury ETFs to a large extent. Below we highlight a few long-term U.S. Treasury bond ETF choices (read: Prepare for Rising Rates with These Inverse & Hedged Bond ETFs).
The choices are:
PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ - Free Report)
Vanguard Extended Duration Treasury ETF (EDV - Free Report)
Vanguard Long-Term Government Bond ETF (VGLT - Free Report)
iShares 20+ Year Treasury Bond ETF (TLT - Free Report)
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