Deficits, the Fed, and Rising Interest Rates: Implications for Bond Investors
Recent cash flows into bond mutual funds and exchange-traded funds have been very strong. A slightly higher percentage of bond cash flows has gone to short-term funds. This is fairly atypical for an environment of extremely low short-term yields.
One of the likely catalysts for this trend has been increased demand from money market investors in search of higher yields. With the Federal Reserve maintaining its federal funds rate target close to 0%, monetary policymakers have made it extremely difficult for many savers to generate sufficient income from their money market accounts. In this sense, savers unfortunately remain the “sacrificial lambs” of U.S. monetary policy as the Federal Reserve attempts to stimulate other segments of the economy.
Another probable influence is increasing concern among bond investors that mounting government debt levels will eventually drive up longer-term U.S. interest rates, which at present are below their historical averages (see Figure 1). In addition, the futures market expects the Federal Reserve to begin raising short-term rates before the end of 2010 as the U.S. recovery strengthens.
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