Barring a major surprise, the Federal Reserve’s policymaking committee looks set to raise its benchmark short-term interest rate by another quarter of a percentage point this week, in the face of strong economic growth, steady inflation and falling unemployment. It would be the first of at least three rate hikes currently forecast for 2018 and the sixth of the Fed’s rate-hiking cycle, bringing the federal funds rate to a range of 1.5%–1.75%.
Here we’ll put the Fed’s policy in context and discuss some of the implications for investors.
The economy and rates
The Fed’s mission is to keep the economy in good health by using its money tools to promote employment and keep prices stable. So how are things going?
Pretty well, or at least well enough for the Fed to continue gradually pushing its policy settings back toward normal after more than a decade of having to support an economy weakened by the financial crisis. Employment has been growing and the unemployment rate falling. Normally, that would raise the risk of surging inflation, but wage growth has been moderate enough to help keep prices rising at a very mild rate.
Meanwhile, the recently passed tax cuts and Congressional deal to boost spending are likely to add more stimulus to the economy, potentially boosting inflation. And the prospect of tariffs on metal imports and other potential curbs on trade could help push prices of imported goods higher.
All things considered, the Fed’s rate-setting Federal Open Market Committee (FOMC) should be able to raise the fed funds rate several more times this year.
“The Fed seems determined to get the funds rate back to ‘neutral” as soon as possible, especially in light of potential inflationary impact of fiscal stimulus,” says Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research. “After several years of promising to hike rates and then backing out, this year is likely to see some follow-through.”
Where the dots point
How much follow-through is actually a matter of debate—and one of the key pieces of information markets will be awaiting when the FOMC wraps up its meeting on Wednesday.
“Fed watchers will be waiting to pore over the Fed’s updated ‘dots plot’— part of the FOMC's Summary of Economic Projections,” Kathy says. “As of the last meeting, the median estimate for 2018 suggested the Fed would raise rates three times this year. However, we believe there is a risk that the median dots estimate could move up to four rate hikes this year.”
“It would take just a handful of FOMC members to shift their dots to get the median to four rate hikes for 2018, and a few of them have already publically suggested that they could raise their estimates,” she says.
After all, even though the Fed has already raised interest rates five times in the current cycle, the federal funds rate is still low by historical standards. In fact, it is still lower than the inflation rate, meaning the “real” rate is still negative. Any signs that inflation is rising are likely to prompt more hikes.
It’s also worth keeping in mind that while inflation is important, the Fed is also keen to restock its toolbox after years of keeping rates low. In order to prepare for the next potential economic setback, the Fed will want to bring rates back to the point where it could cut them again to spur growth if needed.
Effects on markets
Rate hikes don't have a uniform effect across financial markets. For example, rates tend to rise when the economy is improving, and a strong economy is also good for stocks. As a result, the S&P 500® Index historically has risen during rate-tightening cycles. That said, stocks tend to suffer when rates get too high and the stock market generally doesn't like surprises, so if it looks like the Fed is gearing up to boost rates more quickly than expected, things could get bumpy.
It’s a little different in the bond market. How a bond a reacts to changes in interest rates depends in part on its duration. In general, shorter-duration bonds tend to react less dramatically to rate hikes than longer-duration bonds.
For that reason, given the likely trajectory of interest rates, it could make sense for investors to consider keeping the average duration of their fixed income portfolios in the short- to intermediate-term range—say, three to seven years for Treasury securities and investment-grade bonds, and five to 10 years for municipal bonds, Kathy says. Prices for such bonds could still swing, but likely not by as much as for bonds with even longer durations.
“For investors who are uncomfortable with any volatility, short-duration-only could be an option,” Kathy says. “Keeping duration at two years and under won’t generate as much income, but it will help minimize volatility and allow for flexibility to reinvest at higher yields as bond yields rise.”
Another option is a laddered portfolio, which provides similar benefits, Kathy says. Investors should remember that it’s always a good idea to try to match the duration of your fixed income portfolio to the investment time horizon or when you expect to need the money.
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.