It’s a foregone conclusion in the markets that the Federal Reserve will raise short term interest rates on Wednesday. But more importantly, investors will be looking for hints for future rate increases.
Why is this so important? The consensus view is for 2-3 Fed increases this year, but anchoring into this expectation comes with risks. For example, in 1994 the Fed surprised investors by increasing rates 6 times, resulting in a 3% loss for bonds that year. Of course, bonds recovered in following years, thanks largely to the long-term trend of falling interest rates since 1981.
The tragedy in Orlando last Saturday has shaken the nation while rekindling policy debates on gun control, immigration, and terrorism. These issues are among many cited by the pessimists as
catalysts for the end of the bull market in stocks. But the odds are that they’re likely wrong, and here’s why.
The coming weeks bring us the Federal Reserve meeting on interest rates and Britain’s vote on exiting the European Union. And as my colleague Kyle Kersting recently noted, the U.S. presidential election adds regular headlines that jolt markets higher and lower. The problem, however, isn’t the actual risk any of these topics pose, but rather how we feel about such risks.
Fed Chair Janet Yellen’s comments last week suggested that interest rates may be headed higher as early as next week. This caught the market by surprise, given the subpar economic growth and low inflationary environment. But we see a few reasons why higher inflation and higher interest rates shouldn’t be such a surprise after all.
On Wednesday, the Fed decided to put an anticipated rate hike on hold for at least another month. The planned hike was curbed due to the recent volatility experienced in the market. Although the job market has been resilient during this weakened economic period, broader economic factors have caused a period of increased market volatility, measured by the VIX index. U.S stocks have rebounded in the past month, mainly due to improving data, rising oil prices and an accommodative stance by central banks around the world.
When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.
Yesterday the Fed, led by Janet Yellen, made the announcement the investment community has been expecting: A 25 basis point increase in the Federal Funds rate. The Fed voted unanimously to set the new Federal Funds rate to .25%, up from zero. The outlined path will be a gradual increase with a target rate of 1.38% by the end of 2016. Improvements in the job markets and an increasing level of inflation both supported the Feds decision to increase rates.
The increase draws a close to an unprecedented period of low rates that were part of a grandiose plan implemented by the Fed to help stimulate the economy after the turmoil in 2008. The financial markets took the rate increase announcement in stride, reflecting growing conviction among investors that the U.S. is strong enough to withstand higher borrowing costs.
Many investors have the general understanding that fixed income prices move inversely with changes in interest rates. An increase in rates typically results in a decrease in value of the underlying fixed income security. However, many investors are uncertain about the relationship between interest rates and equity markets.
Over the past year, investors have been attentively watching for when, or if, the Fed will raise rates. The Fed has stated its plan to raise rates slowly to avoid derailing previous economic gains. Before assuming that rising rates will detract from the overall health of the economy, let’s focus on how rising rates will affect your portfolio’s allocation to equities.
It is important to understand why the Fed is preparing to raise rates. The Fed has been very accommodating to the economic recovery by holding rates at historic lows. The Fed is not raising rates with a goal of slowing down the economy, but rather to get back to a more “normal” level.
All eyes are on the Fed this week.
What this means is that when the Fed and Central Banks are accommodative to growth…like they have been for a long time…we take other indicators, such as fundamental market valuation indicators, and give them a bit less weighting in our overall assessment of investment opportunities and dangers. Simply put, fighting the Fed or “tape” is typically considered foolish in the world of investing.
Our research indicates that regardless of when the Fed starts increasing rates from the current emergency level, that the increase amount and pace will be low and slow. Here’s a brief snapshot of some reasons why: