Federal Reserve policymakers will meet this week, after raising short-term interest rates at the conclusion of the previous meeting, on December 13. Will members of the Federal Open Market Committee (FOMC) decide to hike rates again this week?
Probably not, according to Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research.
“We don’t expect a policy change from the Fed at this meeting,” Kathy says. “There will be no release of updated economic projections, nor a press conference. It is also the meeting where the transition from Janet Yellen to Jerome Powell as Fed chair will take place, so it would be quite unlikely for any surprise announcement on policy to be made.”
However, Kathy still expects the Fed to raise the federal funds rate target three times in 2018, and she says the likelihood is high for a rate hike in March.
Normally, the Fed raises the federal funds rate—the rate banks charge each other for overnight loans—when it wants to tap the brakes on economic growth and cool inflation before it becomes overheated. And Kathy notes that inflation has been picking up recently, for a few reasons:
- Last year’s slump in inflation will mean that on a year-over-year basis, it will be easy for inflation to rise off of a low base.
- Energy prices have been rising, which is a key component of inflation.
- Consumer spending has risen at a time when inventories are low, which means that demand is strong relative to supply. That should give businesses some pricing power.
- The U.S. dollar is weaker, which tends to push up import prices. In fact, import prices are rising – they were up 3.0% from a year ago in December.
- Wages are beginning to pick up due to the tight labor market, which could fuel more spending and price increases.
“With inflation higher, bond yields should grind higher,” Kathy says. “However, assuming the Fed tightens three times this year, as we expect, the rise in longer-term yields should be muted.”
What bond investors should consider now
Kathy thinks it could make sense to keep the average duration of your fixed income portfolio in the short- to intermediate-term range—three to seven years for Treasury securities and investment-grade bonds, and five to 10 years for municipal bonds—because longer-term bond prices tend to be more negatively affected by rising interest rates. This is also where yield curves are the steepest, Kathy says, so you tend to get the most yield for the risk.
However, there are other options. “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.
Kathy also thinks that that investors should focus on higher-credit-quality bonds. “Late in the business cycle is when valuations tend to get stretched, as they are now in the corporate bond market,” Kathy says. “It may not be worth the small amount of extra yield you get to take on more credit risk at this time.”
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.