Could short-term gains in interest rates mean long-term pain for equity and bond markets?May 29, 2015
According to the Federal Reserve April meeting minutes released after the normal three-week lag, Fed officials generally doubted rates would increase by midyear. According to the Dow Jones report, only a few Fed officials felt confident that unemployment would continue to fall and inflation would trend toward the 2% target in order to justify a rate hike by the June 16-17 meeting. Subsequently, Federal Reserve chair Janet Yellen stated in speech to the Greater Providence Chamber of Commerce on May 22 that ” … if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.”
What’s an investor to make of this murkiness?
Boston-based Julex Capital Management, an investment firm founded on the principle of providing downside protection, interprets Ms. Yellen’s statement as a near-certainty of a 2015 rate hike, projects a 300 basis point increase in the federal funds rate over the next two years, and states two predictions:
- The rate increase will be slow, orderly, and data-dependent. This belief holds constant with what the Fed has reiterated throughout virtually every meeting over the past year.
- Bonds will exhibit slightly negative returns, given that bond prices have an inverse relationship with changes in interest rates.
While we’ve seen what has generally been an up-market since 2009, traditional economic conditions suggest that it may be in the later stages of the upswing. Employment figures have improved, the yield curve has been upward-sloping, but flat, near the long-term maturity range, and stock indices have touched record highs. Historically, what tends to follow is an increase in bond yields and moderate increases in stock prices but at the cost of higher volatility.
Most importantly, how might one make a prudent and informed investment allocation decision based on this information for portfolios consisting of a diversified mix of stocks and bonds?
Clearly, the possibility (some would state, “probability”) of interest rate increases by the end of 2015 would result in a decline in bond prices. However, we continue to believe that a potential increase in equity market volatility given the current state of the market cycle presents a greater risk to investors should equities suffer a correction and pull back from current all-time highs. Furthermore, we expect active fixed income managers to adjust duration accordingly within their investment mandates to minimize adverse price effects from rate increases.