Adjust Strategy as Interest Rates Rise Slowly

Tab 1

December 15, 2016


 

On Dec. 14, the Federal Reserve (Fed) increased its benchmark short-term interest rate by 0.25 percent to a target range of 0.5 percent to 0.75 percent. The previous range was 0.25 percent to 0.5 percent. It was the Fed's first vote this year to increase the federal funds rate, the rate at which banks lend to one another overnight, and it came a year after the Fed raised rates for the first time since 2006.

 

Most investors had expected the latest Fed decision, yet the move to increase rates this year happened more slowly than originally expected. At the end of 2015, the Fed signaled that in 2016 it would raise interest rates four times, by a quarter-point each time. But throughout the year, the Fed repeatedly downgraded its forecast for economic growth during the year, prompting caution about tightening too quickly.

 

 

 

 

 

 

The recent rate increase provides some reassurance that the Fed believes the U.S. economy will continue to improve. Fed officials also signaled that they expect to raise short-term rates in 2017 by another 0.75 percentage point – likely in three quarter-point moves. 

Tab 2

December 15, 2016


Positive economic signs

 

The rate increase may lessen uncertainty in the markets while signaling a healthy U.S. economy, says Robert Haworth, Senior Investment Strategist at U.S. Bank Wealth Management. 

 

“For investors, there’s not a lot that changes the day after a rate increase,” Haworth says. “But in general, I think there will be some relief for the market that this decision has finally been made."

 

Now that the Fed has raised rates twice in the past two years, investors can begin to see the outlines of a trend toward normalization, he explains. “People tend to think that either interest rates are declining, or rates are increasing and financial conditions are tightening,” Haworth says. “While that’s mathematically true, I don’t think that’s actually the experience. There’s a middle ground as the Fed is normalizing interest rates because the economy has improved, and so the interest-rate regime is somewhat catching up with the economy, rather than causing a strain on the economy.”


 

Slow moves call for different strategies

 

Although investors expect the Fed to continue increasing rates, the changes are likely to remain small and slow, says Jennifer Vail, Head of Fixed Income Research at U.S. Bank Wealth Management. “This is not a traditional Fed normalization cycle,” she says. As a result, investors should not expect that the strategies typically pursued during a cycle of rate increases will be as effective as they usually would be.

 

Vail says that normally during this time, investors would buy short-term bonds in the zero to three-year range so that they could reinvest at higher interest rates as those bonds mature. However in this cycle, because the Fed is raising rates slowly and in small increments, investors risk not being able to reinvest in bonds that pay a comparable yield to those that are maturing. Vail says she advises clients to avoid the short end of the yield curve and instead to focus on intermediate bonds, particularly high-yield and emerging-market debt, and high-quality corporate or municipal long-term bonds.

Tab 3

December 15, 2016


Eyes on inflation

 

As the Fed weighs its dual mandate to balance unemployment and inflation, the labor market will continue to look solid, so long as it posts 100,000 or more new jobs a month, Vail says. “I think the single most important factor for the Fed right now is inflation,” she says. Inflationary pressures are starting to appear in both core inflation, or the long-run trend in prices, and headline inflation, which includes more volatile commodities, such as food and energy prices. Average hourly earnings also are beginning to rise. These pressures are likely to influence the Fed to continue raising rates, Vail explains.

 

We expect the Fed to increase interest rates twice next year, Haworth says, adding that the first move is unlikely to happen before the summer of 2017.

 

 

 

 

 

 

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investments in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments.