Weather Forecast, Near 100% Chance of a Rate Hike

Austria, Tyrol, Tannheimer Tal, hiking trail in mountainscape

This week the U.S. Federal Open Market Committee (FOMC) will hold its last meeting of the year. And this time it appears likely that it plans to do something it hasn’t done yet in 2016: raise short-term interest rates. According to Bloomberg, the market is currently pricing in a 100% chance that the Federal Reserve (Fed) will raise rates from the current 0.50%-0.75% range to 0.75%-1.00%. The market’s confidence is driven by recent strong economic data. Job gains have been steady and the unemployment rate has fallen to 4.6%, at the same time the Consumer Price Index (CPI) rate is inching closer to 2% after having spent much of 2015 close to 0% (source: Bureau of Labor Statistics). And overall gross domestic product (GDP) grew a robust 3.2% in the third quarter (source: Bureau of Economic Analysis). All of this looks to have given the Fed confidence that it can go ahead and increase short-term rates, and it has clearly communicated this intention out to the market.

What does a rate hike mean to investors?

This potential increase in short-term interest rates probably won’t have much of an impact on most fixed income portfolios. The forecasted move itself is small, and it mostly affects shorter maturity bonds that do not have as much interest rate sensitivity as longer maturity bonds.

Outside the bond market, there will be slightly higher interest rates for some consumer loans like home equity lines of credit and adjustable-rate mortgages. In return we may see slightly higher interest rates on checking and savings accounts. All in all, we believe the impact for investors should not be significant.

Interestingly, if we look at the capital flows for U.S. fixed income exchange-traded funds (ETFs) in the accompanying chart, there has been quite a bit of activity since the last Fed meeting on November 2.

fi-etf-flows

Although some of the flow activity may be related to the Fed moving closer to raising rates, most of it has occurred since the U.S. election. The new administration has signaled policies such as tax cuts, increased Treasury issuance and reduced regulation that many investors believe could result in higher interest rates, higher inflation and a favorable environment for corporate bonds. Consequently we have seen 10-year Treasury yields rise sharply from 1.86% on November 8 to 2.41% on December 8 (source: Bloomberg data).

Flows since the election have reflected such sentiment. As Treasury rates have risen, investors have pulled back from Treasury securities. At the same time some have moved into TIPs on the expectation of higher inflation. And high yield inflows have been strong on the belief that that sector will continue to perform well. Like EM equities, EM bonds have experienced outflows and poor performance due to concerns about the impact of potentially new U.S. trade policies on emerging economies.

Where should investors go from here?

Investors with shorter-term investment horizons should be cognizant of the impact that rising interest rates have had on their bond portfolios, and be ready for more volatility as the new administration’s policies are implemented beginning in January. But longer-term investors may be best served by sitting tight. Yes, rising interest rates do cause bond prices to fall, and this drags down performance in the short term. Over the long run, however, higher interest rates boost bond fund income payments. Although this may sound counterintuitive, if you are a long-term bond investor, you may actually favor rising interest rates. Higher interest payments may offset the price decline caused by rising rates over time.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

 

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Don’t Fret Too Much About the Fed

Fed Benchmark Rate

Janet Yellen, the chair of the Federal Reserve, has said that the Fed is likely to raise its benchmark interest rate sometime this year. Such a move would be the first rate rise since 2006. Whether the change occurs as early as the Fed’s meeting next week or later in the year is still a matter of speculation, but either way higher interest rates could affect your portfolio. So how much should you fret about the Fed’s potential move? The answer is “probably not too much.”

That sanguine answer isn’t because the Fed doesn’t matter. The Fed’s decisions can affect the value of essentially every investment you own. Rising interest rates could increase bond yields and therefore hurt bonds (since bond prices and yields move in opposite directions). They could potentially slow the economic growth rate, hurting stocks. They could strengthen the US dollar compared to foreign currencies, reducing the values of your international holdings as well as causing commodity prices to decline.

But the Fed has been clear about its intentions to raise interest rates for a while. Even Ben Bernanke, the Fed chair before Yellen took over in 2014, had discussed when and how the Fed would raise interest rates. As a result, many of the effects of higher interest rates may have already occurred in anticipation of the Fed’s potential move. For example, it’s likely that some of the gains for the US dollar compared to foreign currencies during the past year (and the interrelated struggles of commodities and emerging market investments) resulted from the possibility of the Fed raising rates.

Furthermore the Fed may not exactly follow the historical playbook this time around. Usually when the Fed starts raising interest rates, they continue with a series of fairly rapid rate rises over the course of a couple years. That pattern occurred in the early 1980’s, the late 1980’s, the early 1990’s, the late 1990’s, and the mid-2000’s. But Yellen has said that this time the Fed plans to raise rates more slowly than usual.

She may not have much of a choice. Developed countries that have raised interest rates in recent years— including Sweden, Norway, and Australia—have had to quickly reverse course when their economies subsequently stagnated. With the inflation rate still below the Fed’s 2% target and a weak global economy, the Fed is unlikely to raise rates very far or very fast.