Fed spikes volatility in bonds

Linking monetary policy to unemployment, inflation drive big fluctuations

By Dan Jamieson

Dec 18, 2012 @ 3:08 pm (Updated 3:33 pm) EST

federal reserve, economy, bond market, fixed income

Think volatility in the bond market is a thing of the past? Think again.

Investment strategists agree that the Federal Reserve's historic action last week to link monetary policy to inflation and unemployment targets could cause more volatility in the bond markets.

On Dec. 12, the Fed said that, assuming its inflation forecast for one to two years out is less than 2.5%, it would keep interest rates low until unemployment falls below 6.5%.

The action was an indication that central bank officials are still worried about the state of the economy and would be willing to maintain their current federal funds target rate of zero to 0.25% for as long as needed to see a meaningful jobs recovery.

It's also seen as an effort by Federal Reserve Board Chairman Ben S. Bernanke to offer more guidance about how long the Fed will have to maintain its extraordinary efforts to stimulate a sluggish economy.

Although rates look to remain low for the foreseeable future, the linking of rate policy to economic data might cause more short-term fluctuations in bond prices, analysts said.

The market will tend to react to any new economic data, said Jeff Rosenberg, chief investment strategist of fixed income at BlackRock Inc.

“Any positives will ratchet up expectations” about the Fed raising rates, he said, “and more-negative numbers will push [expectations] back.”

“We will have intraday volatility based on the daily news,” agreed Michael Mata, head of multisector fixed-income strategies at ING Investment Management LLC.

For example, the unemployment rate has fallen to 7.7% from 8.3% since summer, said Robert Tipp, chief investment strategist for Prudential Fixed Income.

By extrapolating that trend, “people could say that the Fed could exit [its zero-rate policy] in a year,” Mr. Tipp said. “Or, if we see data the other way, it could look like the Fed won't stop within five years.”

As certain fixed-income sectors sell off, analysts say investors may have some opportunities to capture attractive yields in an environment that will continue to see rates at historically low levels.