A Shift in Federal Reserve Policies

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February 27, 2015


During the past six years, the Federal Reserve invested $3.5 trillion in a bond-buying program designed to ease the country through its latest financial crisis. The Fed program officially came to an end in October in reaction to the substantial improvements made in the employment outlook.

 

“The committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability,” Fed leaders said at their October meeting.

 

Since the announcement, concerns have been raised over how the Fed will maintain stability inthe marketplace as it exits this extraordinarybond-buying policy. David J. Stockton, Senior Fellow at the Peterson Institute for International Economics,  met with U.S. Bank leaders recently to discuss trends in the current economy and how Fed policy will affect future investment decisions. (Stockton is also the former Director of the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.)

“One thing we can say with certainty is that slack is diminishing in U.S. labor markets,” he said, noting that the unemployment rate dropped from 10 percent to 5.75 percent since the credit crisis. This is a promising sign, although indicators such as the pace of hiring, wage growth and willingness of employees to quit their jobs, have been slower to follow suit. “The economy is clearly improving, but it's still the case that this is not a normal labor market,” Stockton says.

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February 27, 2015


He expects an acceleration in wage growth over the coming months as the unemployment rate continues to drift lower, causing labor markets to tighten. As they do, the Fed is almost certain to slowly and gradually normalize rates. The pace of U.S. growth is also taking up slack in the labor and product markets, which Stockton says will drive up inflation modestly, unlike the very low inflation or deflation that is being experienced both in the eurozone and Japan.

 

“My outlook is some acceleration… but certainly not one that is putting substantial upward pressures on business costs that would materially harm the broader inflation outlook,” Stockton says.

 

Potential Implications for Investors

This all has implications for investors, says JenniferVail, Head of Fixed Income Research for U.S. BankWealth Management. The Fed could wait until Juneor later to begin normalizing interest rates, in linewith growth in the labor markets. In response, we are encouraging investors to avoid short term bonds, where interest rates are lowest, and to focus on other areas of the maturity spectrum with different levels of risk and appeal.

“As yield curves flatten (shorter term rates close in on longer term rates), there may be more volatility and risk at the short end, while yields at the long end may not move in tandem,” Vail says.

 

Vail says investors may consider high-yield, dollar-denominated emerging debt, or low single A corporates and municipals with an intermediate term. “These are still investment grade, but they are more volatile with higher yields.”

 

For investors interested in the 15- to 30-year spectrum of the bond yield curve, she suggests looking for high-quality investment-grade corporates, municipals or treasuries. “When you are going long, you want default protection,” she says. The higher quality investment grade bonds may deliver that benefit.

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February 27, 2015


Local Versus Global

From a global financial perspective, the recent gains in the U.S. dollar will be sustained with the potential for more upward pressure going forward, Stockton believes. “That largely reflects the fact that many see the U.S. economy as more attractive versus the other major advanced economies,” he says. “We're doing relatively better, even if we're not doing all that well.”

 

As the Fed is likely to raise rates ahead of other countries, with the possible exception of the United Kingdom, dollar strength is likely to be sustained.

“Again, such divergence among Central Banks reinforces the potential benefit of investing in the longer end of the bond market and focusing on bonds from economies with the strongest growth potential,” Vail says. “Even with yields as low as they are in the U.S., it’s still very attractive compared with other markets.”

 

For more information about how shifting Fed policy and the changing global marketplace might affect your long-term investment decisions, speak with your investment advisor.

 

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