The Interest Rate Dance

Written by David Fabian of FMD Capital Management.     The current rise in interest rates has an eerily-similar feeling to the panic and frustration after the Fed’s surprise announcement to taper quantitative easing in 2013.  Just like then, the bond market is reacting more to the thought of a change in Fed policy and not the change itself.  Investors should always remember that the  markets are not logical, they are psychological.  So with the strong non-farm payroll numbers that were released this morning, there is renewed anticipation that the Fed will be forced to hike in October, instead of the first quarter of 2016.

In my opinion, if a rate hike is imminent four months from now; would an additional four months really soften the blow that much?

The market and the economy are likely strong enough to endure this small quarter point adjustment, yet it’s the negative connotations associated with short-term rate increases that no one wants to confront. The Fed is merely trying to get rate policy off the flat line, so they have room to maneuver during the next recession, which many economists believe we could be overdue for.  So the likely outcome is that we may need to take our lumps now, to allow for some breathing room when we need it the most.

Yet, the problem I have with the market’s reaction over the past few months is the same problem I had when the yield curve steepened in 2013 following the Fed’s landmark announcement.  It’s probably all for none. If the Fed does ultimately raise rates in October, then we are more likely to see longer duration bond prices rise and yields fall, as risk assets have a natural predisposition to correct in that scenario.  The Fed is essentially dis-inflating risk asset prices by raising rates.

Remember that a hike in short-term interest rates doesn’t affect interest rates of 2, 5, 10, 20, or even 30 year Treasury bonds.  It merely affects the discount rate, or the overnight rate that banks and financial institutions levy on each other.  So the longer end of the yield curve will fall, while the shorter end will continue to rise like it has been for quite some time, otherwise known as yield curve flattening.

So even though longer duration bonds have been under a lot of pressure recently, we are more likely to see this reverse alongside a short-term rate hike.  I bring this up because I think it’s important for investors to maintain their sense of clarity, and not begin to panic like so many did during the 2013 interest rate volatility.  Making the mistake of selling bonds in frustration could lead to a general decrease in spendable income, but more importantly prove to be a poorly timed mistake.

At this point, the majority of the rise is probably already behind us, so selling now won’t yield much benefit, unless we see the 10-year Treasury rate surpass the technically significant 2.6% level.  Just keep in mind we’ve gone from a low of 1.65% to 2.4% through today, an increase of 0.75% in just the last 4-months.  For those that remember, this type of volatility was quite normal in a given year post financial crisis.  But in present day, it’s overshadowed as a terribly bad omen.

In addition, investors that have been incorrectly positioned with the majority of their fixed income assets in Treasury bonds or other high quality securities should resist the urge to migrate toward senior loans or other credit heavy securities.  You’ll be glad you stayed put, since they are likely to have additional pressure brought upon them once the Fed begins to raise rates.  The best strategy at this point, especially if you comfortable with active asset allocation changes, is likely to begin considering the purchase of even more fixed-income to take advantage of higher yields, rather than sell.

For clients in our Strategic Income Portfolio, we are considering extending our otherwise extremely short duration to capitalize on recent price fluctuations. Since we have been predominantly more credit heavy, we feel that adding an element of quality back to our portfolio could prove to be a prudent tactic. Especially since we get the benefit of 0.75% more yield than we did just 4-months ago for intermediate duration fixed-income.

No matter how you decide to play this Fed policy conundrum, just be mindful of the past.  Don’t put any credence into the blanket statement that if the Fed raises interest rates, that all rates will in turn rise; because history has taught us that is simply not true.

Listen to our latest podcast on building a low volatility income portfolio here.

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