Some investors are excited by the prospect of higher interest rates. Others aren’t sure what to expect because it’s been a long time since the Federal Reserve increased rates—nearly a decade. On this installment, we’ll talk about what life may be like after the rate hike.
You're listening to the Insights & Ideas podcast brought to you by Charles Schwab. I'm Rick Karr. When rates rise, the stock and bond markets react in different ways. So I have a guest for each market: Schwab's chief investment strategist Liz Ann Sonders for stocks, and fixed income strategist Collin Martin for bonds. They agree that the first move the Fed makes is not the important one for investors. It's what the Fed does next.
Liz Ann says that can provide some insight into what kind of rate cycle is coming.
Liz Ann Sonders
If you go back to the mid 1940s and look at every rate cycle—and there are three categories of them. There's slow, there's fast, and then there's another interesting one to think about which is what is sometimes called the non-cycle or a one-and-done cycle, where the Fed moves once, maybe twice, but then that's it. It doesn't turn into the beginning of a cycle.
And that's the more rare of experiences, although we've had four of those since the mid 1940s. But if you look at the slow cycles, on average, the market in the year after the Fed has begun is up 10.8 percent. In the fast cycles, a year after the Fed initiated a fast cycle, the market, on average, is down I think 2.7 or 2.8 percent. And a non-cycle is up there at around 11 percent, along with the slow cycles.
Collin, is there sort of a similar, I would presume, reverse pattern with bonds?
We like to always point out that, first and foremost, the Fed only controls the Fed funds rate. There isn't one interest rate out there. There's a lot of different maturities, different types of bonds. So when the Fed funds rate does increase, it doesn't mean that all bond yields are necessarily going to rise. Now, investors that are concerned about the negative impacts, that's because bond prices and yields move in opposite directions.
But we like to point out that over time, coupon payments can help offset some of the potential drop in prices. And if you hold bonds to maturity, barring default, you should get paid back the bond's par value at maturity. But higher yields do offer opportunities for investors who've been waiting for the Fed to rise and waiting to kind of increase their savings. So it's really good for savers, because you'll be able to get a little bit more return on your lower-risk investments.
On the other side of that, it does have some negative effects for consumers or borrowers, for example, because things like car loans or mortgages can fluctuate.
Liz Ann Sonders
To add to Collin's point, in a cycle where the Fed is more likely to go slow, which, of course, we think that will be the cycle this time, because inflation is not accelerated—it's not a big risk—which, in turn, should alleviate some of the upward pressure that would exist on longer-term interest rates if we were in an inflationary cycle, which we do not think we are.
It's been feeling to me like for months and months we hear “The job market’s tightening, the job market’s tightening.” Shouldn’t that, at some point push the inflation rate higher?
Liz Ann Sonders
Right. Obviously the transmission mechanism between the Fed's two mandates of employment and inflation is through wages. And you're absolutely right. Wage growth has been quite anemic for an extended period of time.
And many of the factors that historically have kicked in that allow for wages to start to pick up—a sufficient decline in the unemployment rate and job growth picking up, some other measures, leading indicators for wages—all suggest that we should be seeing the beginning of an upward wage cycle. We just haven't yet.
And I think that's one of the reasons why the Fed, even with things like the unemployment rate having come down to 5.1, they've been able to take cover behind very anemic wage growth and the lack of transmission that's had into inflation, which has allowed them to stay with this very easy monetary policy.
Does volatility in global markets play into this at all for the Fed? Or is it really just those two mandates, inflation and jobs?
They're definitely taking that into consideration. For a while, we were in the camp that economic data was good enough for them to hike rates. When you looked at the declining unemployment rate, inflation, although below their target, kind of held steady. And committee members have been consistent with their message that they expect it to rise in the years to come.
But then we saw a lot of market volatility in August, global growth concerns, China, and then they didn’t raise rates in September. So it's clearly something that they're taking into consideration, not that they necessarily have a third mandate now. But it's something that they're being more explicit about. And they are definitely a little worried about rattling, you know, the financial markets.
What’re the specific metrics that the Federal Reserve is looking at as they make this decision?
Liz Ann Sonders
Yeah. There are a whole bunch of various indicators that they look at. I think the inflation data's a little bit more straightforward.
But the jobs data is a little bit more not only nuanced, but there are a number of different metrics that is on the so-called Yellen dashboard of indicators that she looks at. It's not just the standard straight unemployment rate or job creation. But another one that they look at is the JOLTS data, Job Opening and Labor Turnover Survey.
They look within that at the quit rate, so not only how many job postings there are relative to the number of applicants, but also what percentage of workers are voluntarily quitting a job. And that ostensibly means you have confidence in getting another job. So that's a confidence measure.
When rates do rise, do either of you see anything coming that, maybe investors wouldn’t expect?
One thing investors might not expect is how various fixed-income investments perform. Just to kind of look at some numbers, since the Barclays U.S. Aggregate Bond Index—and that's a broad proxy for intermediate-term investment-grade bonds—since its inception in 1976, it's only generated a negative annual total return three times, in three different years, the most recent being 2013. And even then, that was only down 2 percent. So we think investors who are, you know, expecting massive declines are probably overreacting, and performance might not be as bad as you expect.
So our biggest takeaway is that you don't need to panic. We still think if you're in intermediate-term high-quality investments, you can still earn positive returns over the long haul. And if you're looking to get more invested in fixed income, this can offer some opportunities to invest in some higher-yielding assets than you've been used to over the past few years. So we always like to say, you know, it's more important to be invested in the market now than actually trying to time the best time to get in.
If we do expect it to be a slow and low rate cycle, with rates not going as high as some people are hoping for or as high as it's gone in the past, we think rather than waiting and waiting and waiting, we think it matters to stay invested.
We want all of our investors, all of our clients to be invested accordingly, based on their risk tolerance and their time horizon. So when the Fed does finally raise rates, the answer or concern should be, so what? It should be a nonevent. And everyone should be allocated accordingly now, not based on what's going to happen once they do do that.
Collin Martin, thanks a lot for joining us.
Thanks a lot, Rick.
And Liz Ann Sonders, thank you.
Liz Ann Sonders
Thank you so much.
Collin analyzes the bond market at Charles Schwab, and Liz Ann is Schwab's chief investment strategist. She's on Twitter at lizannsonders, L-I-Z-A-N-N-S-O-N-D-E-R-S. That's it for this installment.
The Insights & Ideas podcast is brought to you by Charles Schwab. You can find us on iTunes or go to insights.schwab.com. Our producer is Matthew Nelson. I'm Rick Karr. Thanks for listening.