Could a Fed Rate Cut Be Bearish?

Bbg Rate Cut Prob

After the S&P 500 suffered one of its worst May’s in decades, stocks are rallying so far in June on expectations the Federal Reserve is about to cut interest rates. The next Federal Reserve Open Market Committee meeting is set for June 19, 2019. Based on the Bloomberg World Interest Rate Probability screen (WIRP), markets are pricing in a 20% chance for a rate cut next week, an 84% chance in July, and a more than 94% chance of a rate cut in September.

Beware the Fed Pause and Reverse.

Should investors expect a new equity bull market after a rate cut? We looked at past interest rate cycles most like the current environment, periods when the Federal Reserve began a series of interest rate increases over multiple quarters, paused for multiple quarters, then began a series of rate cuts. It turns out this kind of “pause and reverse” from the Fed is quite rare. Since 1972 there have only been two similar periods. The forward 3, 6 and 12 month returns for the S&P 500 were negative each time.

Fed Pause Reverse

Maybe It’s Different This Time. Maybe Not.

Markets have faced a similar environment only twice in the past 47 years, both resulting in recession and costly bear markets. Two examples are certainly not a large sample size, and of course it could be different this time. But investors expecting a Fed rate cut to automatically result in higher equity prices may be headed for disappointment. A Fed “pause and reverse” may indicate it’s time for advisors to be sure they have a solution for risk management in their asset allocation.

 

For more than twenty years, Anchor Capital has been at the forefront of risk-managed investment strategies designed to help advisors and their clients be more confident in reaching their goals. Anchor Capital is a SEC-registered investment adviser located in Aliso Viejo, CA with over $800M in assets under management. Our investment team has a combined 40 years of experience in the research and execution of quantitative trading disciplines, risk management, and alternative investment strategies.

 

More Myth Debunking

Federal Reserve Building

In a previous SMC FIM commentary, we attempted to debunk the “market timing” myth and presented evidence that showed investors actually lose valuable tax-exempt income by not maintaining a fully invested bond posture. This month we challenge the veracity of another widely held market myth:

“Fed short-term interest rate tightening results in equivalent higher long-term interest rates”

 Many investors mistakenly assume that short-term and long-term interest rate movements are linked through comparable yield movements. However, history disproves this notion.

  • During the last extended period of Fed rate tightening (2004-2006), the Federal Funds rate increased by 425 basis points; however, the 10-year U.S. Treasury yield experienced an increase of only 50 basis points.
  • During this time period, municipal bond yields, as measured by the Bond Buyer 20-Bond Municipal Bond Index, actually declined by 27 basis points. Historically, the movement in tax-exempt bond yields generally fails to match that of Treasury or comparable corporate securities.

We believe there is a good chance that history will repeat itself during the current phase of short-term rate increases. Why?

  • First, think about what long-term interest rates reflect: the expectation of future short-term rates plus a risk premium – the extra compensation for owning a security that will not pay off until sometime in the future. Investors should be paid for market uncertainty. Investing in U.S. Treasury securities does not present any credit risk, so the major risk factor is inflation.
  • As reflected by current bond interest rates, the threat of inflation continues to be constrained. Lack of significant inflation pressure should continue to subdue any meaningful rise in intermediate-term and long-term bond yields, even as short-term interest rates are managed higher by the Fed.
  • The goal under the current Fed program is to normalize interest rates and not to stem an imminent inflation threat. Today’s program is without historical precedent. So, the impact on long-term interest rates this time could be even more muted than what has happened in the past, causing a further flattening of the yield curve.
  • The impact within the municipal market is already being reflected in a flatter yield curve. We believe this is due in part to the significant reduction in net new tax-exempt bond issuance and an increase in retail demand due to changes to the individual income tax code such as the elimination of greater than $10,000 of SALT deductibility.

 

SMC Fixed Income Management (SMC FIM) is a municipal bond advisor and manager that provides customized municipal portfolios for individuals, trusts and estates through its Separately Managed Account Program, and provides advisory services to Unit Investment Trusts.

 

Disclosures

The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management (“SMC FIM”), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.

This commentary is neither an offer to sell nor a solicitation of an offer to purchase securities, any other investments or any other product sponsored or advised by SMC FIM, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. Such an offer or solicitation may be made only by the relevant documents for the relevant investment vehicle and/or investment program. This commentary is not, and may not be used as, a recommendation of any security, investment program or vehicle. There is no assurance that any securities discussed herein will remain in a client’s account at the time you receive this commentary or that securities sold have not been repurchased. The securities discussed do not represent the client’s entire portfolio and in the aggregate may represent only a small percentage of the client’s portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed was or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.

This commentary does not take into account any particular investor’s investment objectives or tolerance for risk. The information contained in this commentary is presented solely with respect to the date of its preparation, or as of such earlier date specified in it, and may be changed or updated at any time without notice to any of the recipients of it (whether or not some other recipients receive changes or updates to the information in it).

No assurances can be made that any aims, assumptions, expectations, and/or objectives described in this commentary will be realized. None of SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders shall be liable for any errors in the information, beliefs, and/or opinions included in this commentary or for the consequences of relying on such information, beliefs, or opinions.

Neither this commentary, nor any of the contents hereof, may be reproduced or used for any other purpose, or transmitted or disclosed in whole or in part to any third parties, in each case without the prior written consent of SMC FIM.

Copyright © 2018 Spring Mountain Capital, LP. All rights reserved.

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.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, and does not apply to the funds.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Persistence of Low Bond Yields

10Y US Treasury Yield 3-16

As the Federal Reserve prepared to raise interest rates last year, fears were rampant that rising interest rates would hurt bond investments by driving up bond yields (bond prices and bond yields move in opposite directions). Yet bond yields have actually declined since the Fed took action in December. Even after a recent uptick amid receding fears of a global recession the yield on 10-year treasury bonds is below 2%, a very low level by historical standards. Should investors still be concerned about rising bond yields?

There’s no immutable law of economics saying that bond yields have to rise back to what historically have been more “normal” levels. The yield on 10-year Japanese government bonds has been below 2% since the late 1990’s, and it’s now below 0% (that’s not a typo; it’s actually negative). Some of the factors that have contributed to these persistent low yields, such as Japan’s aging population, are starting to affect the US and other countries as well.

That doesn’t mean perpetual low bond yields are a certainty. Faster economic growth or a higher inflation rate could push bond yields up, and there are some signs that these trends could be starting to develop. The US economy has added an average of more than 250,000 jobs per month over the past 5 months, and there have recently been indications that inflation, long dormant, may be starting to come back to life.

But even if bond yields do rise from their current levels, they’re unlikely to soar. The global economy is still weak, and the inflation rate, though rising, is still well below the Fed’s 2% target. Furthermore the downward pressure on bond yields from the aging population is likely to continue. Yields may be very low by historical standards, don’t be shocked if they stay that way a while longer.

4 Simple Actions to Consider After Fed Liftoff

Eagle

We finally have liftoff. This week, after months of anticipation, the Federal Reserve (Fed) initiated its first rate hike in nearly a decade, raising the Fed Funds Rate by 25 basis points (bps).

Why not a bigger blast off? The Fed has made it clear that rate “normalization” will happen gradually, meaning rates will likely remain below historical averages for the foreseeable future. But while it may take years to get back to a 4 to 5 percent Fed Funds rate, higher rates are on their way.

The good news for investors is that just a few simple actions can help you prepare your bond and equity portfolios for this new rising rate environment. In the wake of the Fed’s decision, here are four such moves you may want to consider.

1. Consider Your Duration

While longer-duration bonds can provide portfolio diversification benefits, shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates.

Remember, duration is a measure of a bond’s sensitivity to interest rate changes. The longer the duration, the more a bond’s price is impacted. When interest rates change, a bond’s price will change in the opposite direction by a corresponding amount. For example, if a bond’s duration is 5 years and interest rates rise 1 percent, you can expect the bond’s price to fall by approximately 5 percent. Therefore, bonds with higher duration generally have greater price volatility and the potential for losses when rates rise.

2. Focus on Credit

Instead of owning only Treasuries, you may want to focus on adding credit exposure. Credit exposure adds credit risk (the risk that the issuer won’t pay you back) to a portfolio, but it mitigates some interest rate risk. In addition, investors are compensated for taking more credit risk with higher yields, so increasing exposure to higher quality credit risk may enhance income and offset potential price declines due to rising rates.

3. Shift to Cyclical Sectors

It’s important to remember that when rates rise, it’s not just bonds that are affected. Equities are affected too. Higher rates mean that borrowing money becomes more expensive, so it’s harder for businesses and consumers to finance everyday needs. As such, traditionally defensive sectors, like utilities and telecommunications, typically become increasingly vulnerable in a rising rate environment due to their existing large debt positions. At the same time, higher rates generally are a sign of an improving economy, boosting the case for adding exposure to cyclical sectors, which have tended to outperform when the economy is strong.

I prefer to get cyclical exposure through two sectors: U.S. technology and U.S. financials (excluding rate-sensitive REITs). With their large cash reserves, U.S. mature tech companies are much less vulnerable to rising rates than companies in more debt-laden sectors mentioned above. In addition, tech sector revenues may increase if economic growth continues to expand and consumers and businesses spend more. Meanwhile, for some financial institutions, like banks, rising rates could mean higher profits, as net interest margins may increase.

4. Seek New Sources of Income

You may also want to take a look at your dividend strategies when interest rates rise. Although traditional high dividend payers (think the utilities and telecom sectors) have performed strongly in recent years, they’ve become quite expensive by most valuation metrics. And the previously low interest rate environment paved the way for many of these defensive businesses to load up on debt to expand their operations, while continuing to pay high dividends to investors. As such, many of these companies will likely come under pressure when rates rise.

In contrast, dividend growth stocks have historically demonstrated less interest rate sensitivity and may be an attractive way to maintain yield in a rising rate environment. In contrast to high dividend payers, they tend to be more reasonably valued and have more potential to sustainably grow dividends over time.

So, although rates are expected to moderately increase, you can prepare your portfolio now for a rising rate environment by considering simple actions such as these. These simple steps may help to insulate your investments while also capturing new opportunities. Learn more about these four strategies for rising rates, and the exchange traded funds (ETFs) that can help you put them into action, at iShares.com/iThinking.

Funds, such as the iShares Floating Rate Bond ETF (FLOT), the iShares Short Maturity Bond ETF (NEAR) and the iShares 1-3 Year Credit Bond ETF (CSJ), can provide credit exposure with short duration. Meanwhile, the iShares U.S. Technology ETF (IYW), the iShares U.S. Financial Services ETF (IYG) and the iShares Core Dividend Growth ETF (DGRO), can provide exposure to the U.S. technology sector, the U.S. financials ex-REITs sector and dividend growers, respectively.

Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

NEAR is an actively managed fund and does not seek to replicate the performance of a specified index. Actively managed funds may have higher portfolio turnover than index funds.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market. Technology companies may be subject to severe competition and product obsolescence.

There is no guarantee that any fund will pay dividends.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17397

How Rising Interest Rates Affect Your Bond Funds

Finance

The odds of an interest rate rise seem to be increasing. After the October jobs report revealed that the US economy added 271,000 jobs that month and the unemployment rate fell to 5%, predictions that the Federal Reserve would raise interest rates proliferated. Prices in futures markets currently imply that there’s almost a 75% chance that the Fed will hike interest rates in December.

As we’ve argued in the past, you probably shouldn’t fret too much about the Fed. Given the low inflation rate and struggling global economy, even if the Fed takes action in December it’s unlikely to raise rates very far or very fast.

But that doesn’t mean Fed policy will have no effect at all. In fact, the Fed’s actions can affect virtually every investment. One type of investment most likely to be affected will be bond funds. Bonds tend to hurt by rising interest rates since higher interest rates often increase bond yields, and bond yields move in the opposite direction of bond prices. Since bond funds are essentially just a collection of individual bonds, by this logic bond funds should be hurt by rising interest rates as well.

This relationship, however, isn’t quite that simple. Bond funds are indeed hurt if the bonds they hold fall in value due to higher yields. But bond funds are also continually buying new bonds, not just holding on to their existing ones. Over time, the gains from higher yields on these new bonds will partially compensate for the initial decline in bond prices. If you hold the bond fund long enough, your return is likely to be close to the fund’s yield when you first bought it, regardless of what happened to interest rates during that time.

How much you should worry about the effect of rising interest rates on your bond funds therefore depends not only on what the Fed does, but also on the length of your investment horizon. There are ways to minimize the risk of being hurt by rising interest rates, such as by shifting your bond holdings toward shorter-term bonds. But depending on factors such as your investment horizon and your risk tolerance, such tactics may not be necessary.

How to Prepare Your 401(k) for Rising Rates

Checklist

By now, even the most remote tribes of the Amazon must be aware that interest rates in the U.S. may rise as a result of Federal Reserve activity. They’re lucky, because Fed activity shouldn’t have much of an impact on their lives. But for you and me, the people saving mainly through our 401(k) accounts? Reading the press closer to home may have you convinced that the (bond) sky is falling.

If these headlines have you worried, here are some ideas to help you think about your retirement-investing strategy going forward:

Five Ways to Think About Your 401(k) 

1. First, don’t panic when you hear news of rates going up. Yes, you will read about some hedge fund manager making (or losing) millions from interest-rate speculation, but you are not a hedge fund manager. For most of us, the rational course of action is not to react. At least short term. Better to be slow and thoughtful than quick and possibly reckless.

2. Yes, rising interest rates mean that bond prices may fall, but that doesn’t mean the bond fund in your workplace savings plan is going to tank. As interest rates rise, prices of longer-term bonds can fall. But fixed income funds in 401(k) plans typically have a diversified mix of securities, so their sensitivity to interest rates can vary tremendously. That’s the beauty of diversification. Also, remember that interest rates’ rising may be good news in the long-term, as higher rates should eventually produce higher yields from diversified bond funds.

3. Speaking of diversification, it’s probably a good time to refresh your understanding of your investments. Check to see that your fixed income holdings are diversified and you are happy with their management style. You may prefer to basically follow an index, but if you have other options available in your plan, it’s worth considering diversifying with a fund that is actively managed, or has a series of underlying fund managers all within one fund. Knowing that your portfolio is diversified, along with a professional’s regular review of how the fund is performing, should allow you to sleep easier at night.

4. If all this talk of interest rates and bond prices has your head spinning, you may be pleased to hear that most workplace savings plans offer an easy alternative to monitoring the markets—and trying to zig and zag through market turbulence. Target date funds are professionally managed balanced funds where all the asset allocation decisions are made for you. Instead of having to decide what to do about interest rates, you could let the fund’s manager worry about that for you. Target date funds are based on the number of years left before you retire, so they will typically allocate less money to bonds when you’re younger, and more money to bonds as you approach retirement.

5. One other point: If you are retired and trying to maximize your income, rising interest rates may actually be good news. Take the time to visit with your financial advisor to make sure your portfolio is properly diversified, and that you are maximizing income for the years ahead.

Scott Dingwell is a Director in BlackRock’s Global Client Group where he serves on the U.S. and Canada Defined Contribution Team. He writes about retirement for The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-16629

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.

Should You Worry About Rising Bond Yields?

10Y US Treasury Yield 4

2015 hasn’t been a great year for bonds. While US stocks have returned more than 4% since the start of the year and international stocks have done even better, US investment grade bonds are essentially flat. And in the last few months they’ve actually lost money as bond yields have risen (yields move in the opposite direction of prices, so bonds lose value when their yields rise). Is this the start of a surge in bond yields, or simply a short-term blip?

To answer that question, the first thing to note is that the recent rise in yields (at least for US bonds) hasn’t been especially dramatic. The yield on 10-year US government bonds has risen from below 1.7% at the start of February to over 2.2% this week. That increase pales in comparison to the jump from around 2% to around 4% in 2009 and the increase from 1.7% to around 3% in the summer of 2013.

But could the recent rise in yields just be the start of a larger trend? Unlike in 2009, when fears of a global financial collapse were abating, or 2013, when comments by Ben Bernanke sparked fears about the end of the Federal Reserve’s quantitative easing program, there’s no clear economic explanation for why bond yields have risen in recent months.

Government bond yields typically rise because of factors such as an improving economic outlook, higher expected inflation, and (in some cases) the Federal Reserve raising short-term interest rates. But economic statistics suggest that US economic growth has slowed, the inflation rate has remained low, and the Fed is no longer expected to start raising interest rates early this summer, as many economists expected at the start of the year.

The lack of a clear economic explanation suggests that the recent rise in bond yields is likely more of a short-term blip than the start of a larger trend. For investors who are concerned about a continued rise in yields, one way to reduce risk without decimating your asset allocation is to shift your bond holdings toward shorter-term bonds. But bond yields can stay low for a long time, and there’s no economic evidence that the era of very low bond yields has ended.

What Will the Fed Do with Interest Rates?

Inflation Rate PCE

What the Federal Reserve does with interest rates may sometimes seem like an esoteric guessing game, but it can affect almost every investment in your portfolio. The level of interest rates directly affects the return you can get on cash, and indirectly affects how stocks, bonds, and many alternative investments perform.

Last week the Fed tweaked the wording of its formal policy statement, paving the way for an end to the era of near-zero interest rates that’s lasted since the global financial crisis. Most analysts currently believe this first interest-rate increase will occur this summer. But even if that comes to pass, the Fed isn’t likely to raise rates very far or very fast. At the end of 2015, and possibly for a while beyond that, the level of interest rates is still likely to be very low by historical standards.

One reason interest rates are likely to stay low is the state of the economy. Though the unemployment rate has tumbled from 10% in late 2009 to 5.5% in February, there are signs that the economic rebound is fragile. The Citigroup Economic Surprise Index, which compares economic data to analysts’ prior forecasts, has fallen into negative territory. The surge in the value of the US dollar against other currencies since late last year may also act as a headwind for the economy by hurting American businesses that sell their products overseas.

The current outlook for inflation also suggests that interest rates won’t rise very far. The Fed’s preferred measure of inflation, called the personal consumption expenditure index, is only 0.2%. The “core” number, which excludes some of its more volatile components, is 1.3%. These numbers are far below the Fed’s 2% inflation target. Even if the inflation rate does slightly increase later this year as the effect of lower commodity prices wears off, there doesn’t seem to be much of a threat of high inflation that would force the Fed to take drastic action.