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Brace for higher rates: Strategists

Talking Numbers

Bill Gross says the Fed will keep short-term rates low for years to come. But, could a QE taper mean a steepening yield curve and thus higher long-term rates?

Bondholders may be having a tough fall and winter as the US Treasury 10-Year bond's prices fall, but Pimco’s Bill Gross isn't too stressed. Well, not when it comes to short-term bonds, at least.

The co-founder of the world's largest bond fund thinks the Federal Reserve Bank will keep short-term rates low well into 2016, if not beyond.

Gross needs to be right, if just for the sake of his fund. Pimco's Total Return fund has had seven straight months of outflows with a total of nearly $37 billion leaving the fund in 2013. November's outflows of $3.7 billion now leave the fund at $244 billion assets under management.

In his most recent note to investors, Gross says:

“Our primary thrust has been to focus on what we are most (although not totally) confident about, that the Fed will hold policy rates stable until 2016 or beyond. While this and its conjoined policy of QE may have only redistributed wealth as opposed to creating it (picking savers’ pockets while recapitalizing banks and the wealthiest 1% of our population), it is a policy that a Janet Yellen Fed seems determined to pursue. The taper will lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved.”

One of the main tools of the Fed is the overnight lending rate it targets for banks to charge one another, known as the federal funds rate. Since the financial crisis in 2008, the Fed has kept that rate down to a range of between 0% and 0.25%. It was 5.25% the year before the crisis.

(Read more: Fed's Williams: Cutting rate on banks' reserves 'would make sense')

As well, another action the Fed took to keep rates low was to buy US Treasury and mortgage bonds. Known as “quantitative easing” (“QE”), it is meant to add dollars into the financial system and lower rates since higher bond prices means lower bond yields. The Fed has been conducting QE for half a decade, upping the amount to $85 billion each month starting a year ago.

Thus, Gross is saying the Fed might taper QE down to zero in 2014 – which could lead to higher long-term rates – but it will still leave the shorter-term fed funds rate unchanged it achieves its targeted unemployment and inflation rates. That could take a couple of years at least, according to Gross.

“I would agree with him that the Fed is definitely going to keep the short end of the [yield] curve low,” says CNBC contributor Gina Sanchez, founder of Chantico Global. “The question is will the market will play along; what does that do for the rest of the curve? And what we’ve seen so far is the 10-year and 30-year [yields] creeping up while the 2- and 5-year segment of the curve has actually been falling a little, tightening ever so slightly. What that tells you is the market believes what Bill Gross says – that the short end is definitely going to stay low but the long end has been creeping up.”

(See: The Federal Reserve: CNBC Explains)

Talking Numbers contributor Richard Ross, Global Technical Strategist at Auerbach Grayson, believes rates on the US Treasury 10-year bonds are headed up, albeit slowly as well.

“While I’m not going to predict a huge spike in interest rates – I don’t expect them to soar – I think we’re seeing the strongest evidence in years that the primary trend in rates could be higher,” says Ross.

To see the rest of Sanchez’s fundamental analysis and Ross’ technical analysis on where rates are headed next, watch the video above.

More from Talking Numbers:

Four big reasons to stay away from gold: Strategists
Tesla is headed to $160 at a minimum: Strategist
McDonald’s has bigger problems than $15/hour wages

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