After five-and-a-half years of keeping short-term rates in a range of 0 – 0.25%, many market participants believe the Federal Reserve (Fed) is now about 12 months away from hiking interest rates. This may affect markets in the months and quarters ahead as investors begin to brace for a change in policy.
Over the five-and-a-half years since the Fed took the federal funds rate down to a range of 0 – 0.25% on December 16, 2008, participants in the fed funds futures market have had varying views on when the Fed may begin to raise rates for the first time. Figure 1 shows the number of months until the fed funds futures yield will move above the 0 – 0.25% range priced into the futures market at the end of each month. Figure 1 also shows the 10-year Treasury yield (shown with an inverted scale), revealing how in sync long-term bond yields have been with the outlook for short-term rate moves by the Fed.
With the participants in the futures market pricing in the first rate hike at 12 months away, 10-year Treasury yields should be between 2.5% and 3.0%, based on the past five-and-a-half year relationship between them. The 10-year yield is at the low end of that range now. However, if this relationship persists and the year ends with market participants still thinking the Fed will hike rates in July 2015, the 10-year yield may end this year in a range of 3.0 – 3.5%. Of course, the markets have been wrong repeatedly over the past five years on how soon the Fed may hike rates.