The Federal Reserve has been tapping the brakes on economic growth over the past 18 months, raising a key short-term rate several times in an effort to keep the economy from overheating.
However, the bond market isn’t convinced the Fed will continue to raise short-term interest rates. The futures market is assigning only about 30% chance of a rate hike later this year and has discounted very little increase in rates in 2018.
The market’s skepticism has been fed by the persistence of low inflation. Can the Fed keep raising rates if inflation remains low or trends lower?
Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research, thinks the answer is yes. “More rate hikes are likely, because the Fed would like to get policy back to normal now that the risk of deflation has receded,” she says.
That’s because with interest rates still very low, and the Fed’s balance sheet full of Treasury securities purchased in the years following the 2008-2009 financial crisis, the central bank has few tools to deal with a potential future economic downturn, she says. The Fed recently announced plans to begin reducing its balance sheet, and its economic projections suggest one more rate hike in 2017.
The Fed is also likely to tighten policy because of concerns about asset-price bubbles developing, Kathy says. “Several Fed officials, including Fed Chair Janet Yellen, have indicated concern recently about high valuations in some markets, particularly stocks and high-yield bonds,” she says.
Just because the Fed chair says markets are overvalued doesn’t mean those markets will go down. However, it could mean the market may be underestimating the Fed’s determination to raise rates.
“The more the market underestimates the Fed, the riskier it gets,” Kathy says. “In the first half of the year, risky assets did very well. The strongest performing currencies were the Mexican peso and the South African rand. High-yield bonds and emerging market bonds also posted strong returns. That is not what usually happens when monetary policy is tightening in the world’s major economies.”
The one thing that could stand in the Fed’s way would be a deterioration in the labor market, but that doesn’t seem likely any time soon, Kathy says.
“It looks like the economy is in a self-reinforcing cycle where solid job growth leads to solid consumer spending, which is keeping the economy chugging along at a 2% to 2.5% pace” in terms of gross domestic product growth, she says. “It isn’t anywhere near the pace seen in previous expansions, but it seems to have momentum.”
What investors should consider now
Because longer-term bond yields tend to be more sensitive to interest-rate changes than shorter-term bonds, Kathy suggests keeping your average fixed income portfolio duration in the short-to-intermediate term for now. Limiting average duration to the three- to seven -year (as far out as seven to 10 years for municipal bonds) area provides exposure to most of the yield curve, while potentially limiting volatility, she says.
She also suggests sticking to high-quality bonds, for the most part. Investment-grade corporate and municipal bonds, along with Treasuries and certificates of deposit (CDs), should be less volatile than lower-credit-quality bonds like high-yield or emerging market bonds, Kathy says.
Investors may also want to consider investment-grade floating rate notes, she says. Floaters, which have very short durations and pay income linked to short-term rates, may benefit from rate hikes by the Fed. Bank loans are also another option—but remember that these are considered aggressive income investments as they are high-yield and less liquid than most bonds, she says.
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.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.