Where are interest rates headed? Anyone following financial markets over the past few years undoubtedly has this question burning in their mind. At this juncture, while debate continues to surround the timing, most market watchers seem to agree that rates are poised to go up.
Admittedly, an outlook for higher rates has been commonplace across the market for a period of years and yet, aside from fits and starts, rates somehow appear tethered to historic lows. Is this the new normal? Or is the recent tick higher finally the beginning of a long-term trend upward?
From a timing perspective, we agree that higher rates are probably not far off. There are a number of factors informing our view, and we describe them below.
That being said, the interest rate conversation is also quickly shifting toward what happens after the first policy rate hike. Will the Federal Reserve continue on a path of predictable hikes? Will they be sporadic and small? In what follows we will briefly explore this next phase of the discussion as well.
Why should rates go up?
The improving economy is perhaps the foremost contributor to the view that rates are more likely to rise than fall. While real GDP growth has only been in the mid-2% range over the past several years, the all important labor market is finally beginning to show distinct signs of tightness. For example, backward looking indicators such as jobs growth and unemployment paint an image of a much healthier hiring environment. Other data such as the Job Openings and Labor Turnover survey show that many more jobs are available and, in many cases, employees are feeling comfortable enough to voluntarily leave their current position in pursuit of other opportunities. At the small business level, hiring intentions are at some of the strongest levels since the last recession.
A tighter labor market should help drive a pick-up in wages, and signs that this is happening are getting clearer. For example, the year-over-year change in average hourly earnings reestablished an upward trend during the first half of 2015, accelerating back above 2%. Similarly, the employment cost index has formed an unambiguous upward slope. Yearly growth in the total compensation index rose to 2.6% in March; one year earlier it was rising at a 1.8% rate. A quicker pace of income growth could help lift inflation, which has been stuck below the Fed’s 2% target for years (according to the core measure that excludes changes in food and energy prices). Perhaps more importantly, inflation expectations are also on the rise.
In the Fed’s mind, the ongoing progress in labor markets and diminishing threat of deflation places it ever-closer to satisfying its dual mandate of full employment and price stability. The tone of recent commentary from members of the Federal Open Market Committee suggests that they are closer to moving away from the near zero interest rate policy in place since December 2008.
There’s also a growing sense among market pundits that the Fed is at least a little bit anxious to boost interest rates because it would signal to the world that the Fed’s post-crisis policy prescription was successful. A rate hike is a move toward policy ‘normalization’ and—assuming the economy continues to expand despite higher rates—it may help silence some of the naysayers that believe the central bank’s actions have been largely ineffective. Additionally, if rates go up and the economy begins to falter, the Fed will have at least some latitude to ease policy again through conventional means. This is important because when the policy rate is effectively zero, the Fed has fewer options to combat economic weakness. Hence the move toward multiple rounds of quantitative easing during recent years.
What happens following the initial rate lift-off?
After the Fed’s first rate hike, we believe the subsequent path upward is most likely to be characterized by relatively small adjustments to policy rates, and we do not expect these changes to occur at regular or predictable intervals. Rather, we believe the Fed will continue to base its decisions strictly on incoming economic data.
We continue to see little evidence of excess or extremes in the economy that could be construed as precursors to the next recession. Against a backdrop of ongoing slow improvement in labor markets and a measured pace of rising wages, the overall economy should remain on a path of slow growth. In such an environment, the Fed is unlikely to aggressively tighten policy or tighten in a regimented fashion without specific regard for the robustness, or lack thereof, in economic reports.
Clearly, the primary area of focus among the Fed and investors continues to be the labor market. As it tightens, upward wage pressure should build and feed into inflation and inflation expectations. Lately there have been slightly more distinct indications that income growth is accelerating, but it is far from certain that this will continue and ultimately result in a meaningfully faster rise in consumer prices. That being said, if these factors did begin to expand at a much quicker pace, our expectations for the timing and size of further policy rate adjustments would also shift commensurately.
With regard to investment positioning, if we are truly at the beginning of a trend toward higher interest rates, fixed income investors must be keenly aware of the interest rate risk and capital risk that comes with it. Navigating these risks is best accomplished with the aid of an active management investment approach. Specifically, investors need the flexibility to adjust portfolio positioning in areas such as duration (i.e. sensitivity to changes in interest rates), sector exposure, and credit quality when rates are moving higher. Static allocations, or passive approaches that mirror index positioning, could contain substantial hidden risks as conditions change. For example, the Barclay’s Aggregate Bond Index currently contains a large allocation to low yielding U.S. Treasury securities . In our view, these yields are too low to compensate investors for the risk of capital loss should rates move higher and trigger a sell-off in Treasuries. In this scenario, the drop in bond price would likely overwhelm the low yield and result in negative absolute returns if the bond were sold prior to maturity. The duration of the Barclay’s Index has also been extending during recent years which could be a source of risk as rates rise. Index duration at the end of the second quarter was 5.63 years, about 31% longer than where it stood at mid-year during 2010.
Despite the challenging environment in fixed income markets, investors will continue to look to the asset class for the combination of income, capital preservation, and absolute return potential it can provide. Long-term investment opportunities will always exist in bonds, but we believe investors need an experienced manager with a well-defined and consistent investment process to help capture them. Remaining active and flexible as rates rise will be critical to keeping clients on the path toward achieving their long-term investment objectives.
Analysis: Manning & Napier Advisors, LLC (Manning & Napier).
Sources: FactSet
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