Portfolio Discussions: Fed rate hikes
After a brutal recession and a painfully slow recovery, the U.S. economy no longer needs emergency measures of support from the U.S. Federal Reserve. Policymakers began the process of normalizing monetary policy at the end of 2015, and although the Fed is raising rates because the economy is healthier, the prospect of higher rates has created consternation and angst among some investors.
The Fed has hiked interest rates because the economy is healthier
- In 2008 and 2009, the U.S. economy was in dire straits. The “Great Recession” took a huge toll, resulting in significant weakness across a range of economic measures, including jobs, housing and business spending.
- Today, the economy is much healthier than it was during the crisis, suggesting that the emergency level of monetary medicine administered by the Federal Reserve is no longer warranted, or appropriate.
Mind the gap between the Fed and the market
- While the Fed’s own projections are for a slow and gradual rate hike cycle, futures pricing suggests that the market thinks rate hikes may be a bit slower. The key thing to watch will be how market expectations adjust to the Fed’s new forecasts, as a Fed that hikes more quickly than the market expects could lead to upward pressure on the U.S. dollar and tightening for the U.S. economy.
- The Fed released details of how they plan to normalize the balance sheet, which could begin later this year. They will allow $6bn in Treasuries and $4bn in MBS to mature each month, using this in conjunction with rate hikes to determine policy going forward.
Stocks have generally tolerated rate hikes in the past
- As long as a gap between the Fed's expectations and the market's expectations remains, there is a risk of an uptick in volatility.
- However, volatility is normal and should be expected. Furthermore, equities have tended to perform fairly well during past rate hikes, largely reflecting improving economic conditions.
- Fixed income has been a bit trickier. As a result, investors should be well diversified in order to prepare for a range of outcomes, and take advantage of opportunities.
- Rate hikes are not a reason to abandon equities. Investors, however, should prepare for volatility as the Fed continues hiking rates.
- Fixed income investors can expect the short end of the yield curve to rise as the Fed normalizes policy, but longer-dated bond yields should remain low due to continued demand for duration and easy monetary policy abroad.
- Investors should remember that the Fed is only considering rate hikes because the economy is healthier than it was in the aftermath of the crisis. Overall, this is a good thing.
Focusing on different asset classes or regions, Portfolio Discussions help to frame investment conversations using slides from the Guide to the Markets.
The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries selected for the fund’s portfolio or the securities market as a whole, such as changes in economic or political conditions. Equity securities are subject to “stock market risk,” meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time. When the value of a fund’s securities goes down, an investment in a fund decreases in value. Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops.