Janet Yellen has been confirmed as the next US Federal Reserve Bank chairman to succeed Ben Bernanke and so far the financial markets like the decision. Both fixed income and equity markets rose immediately after Yellen’s speech to the Senate Banking committee last month during her confirmation hearing. Later, markets again cheered her official approval by the Senate committee which virtually assures her formal appointment to begin the post early next year. As expected, the tone of her initial speech was widely considered ‘dovish’ or supportive of low interest rates at least for the next few months ahead.

Yellen, currently the Federal Reserve vice chair and long-standing proponent of quantitative easing (QE), met expectations by indicating an ongoing commitment to the Fed’s massive bond buying programme which currently purchases $85 billion in Treasury bonds and mortgages each month. The intended effect of this unprecedented monetary stimulus has been to boost the economy by lowering longer term borrowing rates.

Lower interest rates are recently credited with helping stoke the sluggish US economy and thereby beginning to reduce the nation’s unemployment rate which remains historically high. Falling mortgage rates are considered to be a major reason for this year’s resurgence in home prices across the country as well as rebounding automobile sales. Indeed, both the economy and financial markets appear to be responding well to the latest QE. However, investors are clearly nervous about any further indications of reducing, or ‘tapering’ the amount of bond purchases which could begin to reverse this happy trend.

Markets caught a glimpse of the potential effects of paring bond purchases earlier this year when Bernanke’s comments suggesting imminent tapering sent longer term interest rates up to an annual high and bond prices tumbling. During the ensuing months, mortgage refinancings ground to a halt and the economy began to stall by last September.

Since then, the Fed has backtracked substantially on the idea of tapering and Yellen’s Senate speech suggested she would support further QE for the time being. She believes the economy must see a more sustained recovery before beginning to taper, stating in her speech “We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession.”

Notwithstanding the constructive outlook conjured by a ‘Yellen Fed’, other factors could have an offsetting impact. Notably, last month’s unexpected spike in America’s monthly jobs report and an overall ‘risk on’ environment have already pushed longer term interest rates modestly higher and could remain a factor.

Employment growth has been cited as the most important near term goal for the Fed. However, a few weeks ago, most analysts were caught off guard by October’s surprisingly robust payrolls report deemed even more telling as it occurred during the time of the 16-day government shutdown. The report showed that 204,000 non-farm payrolls were added in October, vastly exceeding the median consensus of 120,000.

Furthermore, the prior two months payrolls were revised upwards by a total of 60,000 jobs. While the monthly job numbers have been notoriously erratic this year, a sustained recovery in employment would force the Fed to consider tapering more seriously.

In addition to the threat of Fed tapering, another factor putting upward pressure on bond yields is an overriding ‘risk on’ environment. When the economy is strengthening and equity prices steadily moving upwards as they have lately, investors typically begin to feel more comfortable with risk and switch from money market accounts and bond funds into stock funds.

A broad rotation from stocks to bonds may in fact be underway. Morningstar Inc, an independent research firm, recently reported that investors are placing more cash into US stock mutual funds than they have in 13 years. Stock funds added $172 billion in the year’s first ten months, the largest amount recorded since 2000 according to the firm. The move marks a reversal from the four years through 2012, when investors placed $1 trillion into fixed income funds during the aftermath of the financial crisis.

While Fed tapering speculation and bond fund outflows may continue to pressure rates higher, other factors are likely to cap the extent of a rise. Key offsets include a steadily ageing developed world population, slowing global growth impeded by the stumbling economies in Europe and many of the developing markets, and relatively benign headline inflation numbers.

Moreover, the Fed appears committed to keeping short term interest rates pinned near zero at least for the next year or more. Short term interest rate increases (what the Fed can most directly control) would most likely not occur until the experiment with tapering is complete. This means a rise in the central bank lending rate would likely be well over a year away.

In the months ahead, the Fed is expected to give further guidance about tapering and may be forced to do some early next year just to maintain credibility. Some economists are now suggesting that the Fed will announce tapering early next year, but will temper the impact of their signal by establishing a lower unemployment rate target, perhaps dropping the level from 6.5 percent currently to 5.5 percent. That would give Yellen and her colleagues more wiggle room in keeping rates lower for longer if necessary.

The bottom line is that the ‘Yellen Fed’ will be quite similar to the ‘Bernanke Fed’. We expect to see bond markets trading in a range of 2.5 percent to 3.0 percent over the next year as measured by the benchmark ten-year Treasury bond yield. While higher yields are now available on longer term securities, we see short term interest rates pinned near zero for at least the next 12 months and likely further.

Returns in fixed income will continue to come from picking up extra yield or credit spread on instruments trading above comparable US Treasury note yields. Bond investors holding investment grade securities will also benefit from ‘riding down the credit curve’ as securities become better bid over time as they approach maturity.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.