Why Treasury Bonds Could Rise In This Interest Rate Environment

The Federal Open Market Committee voted to raise rates for the second time in three months, on March 15, 2017. The primary reason for the Federal Reserve increasing its benchmark interest rate by 25 basis points was due to the increasing confidence that the economy has the potential for growth under the Trump administration.

That said, market participants were already pricing in an interest rate hike. Now, on Tuesday, March 14, 2017, the CME FedWatch Tool indicated market participants were placing over a 90% probability of a 25 BPs rate hike.

The Federal Reserve also indicated that there could be two more rate hikes in 2017, signaling attentiveness as inflation approaches the Fed’s 2% target. The FOMC stated, “In view of realized and expected labor market conditions and inflation, the committee decided to raise the target range for the federal funds rate…Near-term risks to the economic outlook appear to be roughly balance.”

Again, FOMC officials have remained glued with the gradual approach to tightening the current U.S. monetary policy. The median projections for three 25 BPs increases in 2018. However, the median Fed funds rate estimate rose to 3% for 2019.

According to trader Jason Bond, “The FOMC interest rates will have a large effect on the markets, some ETFs I’m following are TLT and EUO currently, as well as GDX, which could benefit during a rising interest rate environment.”

Here’s a look at the dot plot:

The Fed also stated, “The committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal…The committee expects that economic condition will evolve in a manner that will warrant gradual increases in the federal funds rate.”

Here’s a look at the CME FedWatch Tool for the Fed’s meeting in May 2017:

Treasury Bond ETF in Focus

Since the Fed raised interest rates and could raise rates two times in 2017, there is one bond ETF that investors should keep an eye on. Although bonds and interest rates have an inverse relationship, we did not see this relationship unfold today. After the Fed announced it would raise interest rates, the iShares Barclays 20+ Yr Treasury Bond ETF TLT saw a drop. However, by 3:00 PM ET, the ETF was up over 1.25% on the day.

According to one trader in his ETF newsletter, “Despite the potential rate hike causing TLT to fall, rising interest rates could be good for bonds as it would provide more attractive yields over the long term. Now, if rates rise, TLT fund managers would be able to reinvest cash flows at higher yields, which would make up for the short-term falls if and when rates rise. That being said, this is a long-term play, and TLT could rise and provide attractive yields over the medium to long term.”

Moreover, according to Matthew Tucker CFA, bond ETFs could actually be good for long-term investors when interest rates rise. Fund managers are able to reinvest cash flows at higher interest rates, which would boost income. Over the long term, the increased income from reinvesting at a higher interest rate could offset the short-term decline when rates rise.

That said, market participants already seem to be pricing this in even though the Fed raised rates, TLT was up on the day.

The Bottom Line

The Federal Reserve just raised rates as the current level of inflation is reaching the Fed’s target rate. That said, Treasury bond funds could benefit over the long term, since fund managers are able to reinvest cash flows at a higher rate, which would offset the potential fall over the short term due to a rate hike.