Although the timing isn’t entirely clear, it is very likely that the Fed is going to raise short-term interest rates sometime this year. Just last week, the Fed dropped the word “patient” from its policy statement but also indicated that a rate hike in April is unlikely.

In anticipation of an interest rate hike later this year, there are some investors who instinctively want to sell out or lower their positions in bond ETFs and other bond holdings. Meanwhile, there are other other investors that look at the equity market and think that they’re overheated and volatile and they’re seeing safety in bonds.

Rising rates and market volatility and their implications for bond ETF investors was the topic of conversation during Charles Schwab’s Every Third Friday monthly conference call series on ETFs.

Brett Wander, chief investment officer of fixed income for Charles Schwab Investment Management, broke down some common misconceptions that many bond ETF investors are having right now.

The first misconception: Many might think that if the Fed is raising rates that the economy must be in pretty good shape.

“In a typical environment where the Fed is on the verge of raising rates – if you look historically – it means that the economy has really been doing quite well and heating up and there are signs of inflation, the employment picture looks strong, and the Fed is really trying to put on the brakes,” Wander said.

That’s not exactly the case for the current environment, though.

“[T]he economy … is certainly in better shape than it has been over the last couple of years, and things are improving,” Wander said. “The misconception is that the economy is in good shape and I think Janet Yellen underscored some of those points in testimony on Wednesday.”

Wander outlined “three fundamental aspects to the employment picture” that the Fed is concerned about that show the economy still has room to grow.

  1. Labor force participation. In other words, Wander said, how many people are really working given how many people could be?  “As we know, the unemployment rate, which is on the lower side at 5.5%, only looks at the number of people that are looking for a job,” he added. “There are so many people out there that could be looking for a job but have basically given up. And that is captured by the labor force participation rate, which is still really low. That’s a big concern for the Fed.”
  2. Wage earning levels. Those still haven’t recovered, Wander said. “The unemployment rate is low, but we’re still seeing wage levels that are below and not rising anywhere near the level that the Fed would like to see them at.“
  3. How long it takes for unemployed people to find a job? “If you look at past post-recession environments, in the current environment people are taking a lot longer to find a job than they had in the past.” Almost two or three times as long, Wander said.

“The labor market really isn’t anywhere near as good as the Fed would like to see them at,” Wander said.

The second misconception: Conventional wisdom says that if the Fed raises rates, longer term bonds will likely underperform.

Wander said he gets this question all the time.

“It’s one of the most common misconceptions out there in the marketplace,” he said. Adding, “what people frequently will say is, ‘Well if rates generically are rising, why would I want to hold a bond fund? Why would I want to invest in a bond ETF?’”

The important insight here, Wander said, is that not all rates are the same.

“The Fed controls short-term rates,” he said. “They have very little influence on longer-term rates. Longer term rates, I’m referring to 10-year securities, 15-year securities, 30-year securities. The yields on those securities, which we’ve seen come down significantly over the course of the last several years, could still stay at very low levels and there’s no reason to assume that they’re going to rise.”

Because longer term rates are driven by growth and inflation, the Fed’s actions should have little impact on longer term rates.

“So, regardless of what the Fed does – the Fed could raise rates tomorrow, the Fed could raise rates to 2-3% – that doesn’t’ mean that longer term rates are going to rise,” Wander said. “And, in fact, if the Fed is aggressive in raising rates, that could cause long-term rates to fall even further.”

Wander explained that if the Fed is too aggressive that could cause growth and inflation to come in even lower than expected and that could actually cause long term rates to fall.

“And we actually saw that the last time the Fed was on a rising rate regime back in 2004-2005,” Wander said. “If you look at longer term bond yields, they actually fell during that period and that’s not all that uncommon.”

The third misconception: If the Fed raises rates, short-term bond returns will turn negative.

A lot of people are concerned the Fed is going to raise rates and therefore experience negative returns on the short maturity fixed income securities that they hold either in bond funds or ETFs.

“The important point to emphasis here is that returns will only be negative if the Fed raises rates at a rate faster than what’s expected,” he said. “As long as the Fed doesn’t raise rates at a speed faster than what’s expected than fixed income securities on the front end of the curve returns will still be positive. “

Wander said this is also tied into the concept of “rolling down the yield curve.”

“As long as investors are investing out, say, 1-year, 12 months, 18 months etc.,” he said. “Over time those securities can merge towards par, even if rates are rising because they’re rolling down the yield curve. And that’s a really important concept.”

The fourth common misconception: Futures and forwards markets tell us when the Fed will raise rates.

“There tends to be this sense that if you just look at the futures market that’s going to tell me what’s going to happen,” Wander said. “And the futures market has been wrong, for quite some time.”

He said people will typically look at Fed Funds futures or Eurodollar futures or futures in the bond market to get an assessment of the timing of the next Fed rise in rates.

“There’s variability there, and those markets change daily,” he added. “They certainly changed on Wednesday, when we heard Janet Yellen’s comments and her expectations. So, to rely on market expectations in terms of the timing of the Fed rise in rates could often lead to the wrong conclusions.”

This is why Wander says investors need to be “a little cautious and careful” when looking at the futures market.

“It was a common assessment earlier this week that there was about a 50% likelihood that the Fed would raise rates in June,” he said. “Today the common perception is that there is about a 20% likelihood that the Fed would raise rates in June based on what’s priced on the marketplace. Now, I could say it’s probably closer to 10%.”

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