# Fed watch: Prepare for more bond market volatility
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2017-04-10
Category: FINANCE
Category URL: https://financedigest.com/category/finance
Meta Title: US Federal Reserve March Meeting Minutes Analysis
Meta Description: Investment Director David Absolon breaks down the implications of the latest Fed minutes, signalling potential interest rate hikes and market volatility
URL: https://financedigest.com/fed-watch-prepare-for-more-bond-market-volatilityhtml

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By **David Absolon,** Investment Director at Heartwood Investment Management

More often than not the minutes of central bank policy meetings offer few surprises. However, it is worth paying attention to the latest US Federal Reserve (the Fed) minutes of the March meeting.

The higher level of conviction in the US economic outlook was notable, implying that the ‘dot plot’ – [Fed policymakers’ interest rate forecasts for this year](https://www.financedigest.com/u-s-dollar-rallies-to-more-than-2-year-hike-on-steep-fed-rate-hike-outlook.html "U.S. dollar rallies to more than 2-year hike on steep Fed rate hike outlook") – will be realised. This has not been the case in recent years. Indeed, while economic activity has been softer in the first quarter, policymakers believe the influencing factors to be seasonal and therefore transitory. Rather, they view the balance of [risks as being skewed towards the upside based on an economy](https://www.financedigest.com/uk-economy-to-shrink-in-2023-risks-lost-decade-cbi.html "UK economy to shrink in 2023, risks ‘lost decade’: CBI") at or near full employment, supportive financial conditions, and expectations (even though delayed) of expansionary fiscal policy.

More surprising, though, was the discussion around unwinding the Fed’s $4.2 trillion [balance sheet](https://www.financedigest.com/decoding-balance-sheets-analyzing-assets-liabilities-and-equity.html "Decoding Balance Sheets: Analyzing Assets, Liabilities, and Equity"). All other things being equal, if the US economy performs as [expected and we see gradual interest rate hikes](https://www.financedigest.com/dollar-slips-before-expected-fed-rate-hike.html "Dollar slips before expected Fed rate hike"), then the Fed would consider slowing the current policy of reinvesting the proceeds of maturing bonds: around $425 billion of US treasury and mortgage-backed securities are expected to mature in 2018.

**What does this mean for the market?**

Based on current [market pricing](https://www.financedigest.com/markets-pricing-some-geopolitics-but-risk-premia-can-grow-further-goldman.html "Markets pricing some geopolitics, but risk premia can grow further -Goldman"), bond investors are not yet entirely convinced that the Fed will tighten policy as much as it potentially suggests. The yield spread (interest rate difference) between the five-year and thirty-year maturities is at its narrowest level since 2015. Given the glacial pace at which the Fed has moved interest rates over the last year, the [bond market](https://www.financedigest.com/britains-bond-market-turmoil.html "Britain’s bond market turmoil") has probably been right not to believe the Fed. However, it might be wise for investors to start listening to policymakers now. In our view, the [Fed minutes](https://www.financedigest.com/shares-choppy-u-s-yields-fall-as-investors-digest-fed-minutes.html "Shares choppy, U.S. yields fall as investors digest Fed minutes") suggest that policymakers want to move faster, albeit in a gradual fashion, than the bond market would like in terms of its overall ‘normalisation’ process.

The consequence of a US [treasury market](https://www.financedigest.com/u-s-stock-markets-treasury-yields-perk-up-oil-falters-as-choppy-week-winds-down.html "U.S. stock markets, treasury yields perk up, oil falters as choppy week winds down") playing catch-up with the Fed is likely to introduce higher levels of interest rate volatility. We would also expect upward pressure on the term premium – the compensation investors receive for [inflation and interest rate risk](https://www.financedigest.com/hungary-ramps-up-rate-hikes-as-war-stokes-inflation-risks.html "Hungary ramps up rate hikes as war stokes inflation risks") – which would result in tighter financial conditions. Higher levels of volatility and higher yields could be further accentuated in an environment where other global [central banks](https://www.financedigest.com/central-banks-start-turning-off-the-cash-taps-2.html "Central banks start turning off the cash taps") are looking to step away from ultra-accommodative policies, such as the European Central Bank. We also have to consider that the Fed could [see a regime change](https://www.financedigest.com/the-sepsis-therapeutics-market-to-see-through-the-probable-sea-change-through-digitization.html "The Sepsis Therapeutics Market to see through the probable sea change through digitization") in early 2018, with potentially a new Chair and Vice Chair, adding to uncertainty around future policy.

We believe all of these factors continue to support our [view of being wary of global](https://www.financedigest.com/global-equities-waver-on-inflation-view-as-falling-oil-supplies-lift-prices.html "Global equities waver on inflation view as falling oil supplies lift prices") duration.


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