Factors Driving Interest Rates Higher this Summer
FRAN RODILOSSO: Yields in U.S. treasuries have jumped dramatically since early May. While there are several factors contributing to the rise in interest rates, the main one has been the thought of the Fed beginning to taper its asset purchase programs. Effectively, the Fed has been pursuing a very accommodative monetary policy in several forms for several years now.
The zero interest rate policy is really not in question right now as it is something the Fed is likely to continue well into 2014 and possibly even beyond. However, the Fed started dropping hints in May that it was considering an exit from the quantitative easing via the asset purchases and the market reacted quite violently to the notion of the Fed tapering. As U.S. economic data has improved over the summer -- albeit marginally -- the market is factoring a greater probability -- and the Fed supported the market in those thoughts from its own comments -- that tapering is more and more likely to begin this fall.
Can Interest Rates Continue to Rise?
RODILOSSO: There are reasons for the rise in interest rates to continue. There are so many factors involved but should U.S. economic growth accelerate beyond current expectations -- we're looking at moderate growth right now and moderate improvements in employment – including inflationary expectations to spike higher in the near term, then you could see the market react quite violently. It may not cause another one-plus percent jump in ten-year yields but if the market gets a sense that the Fed is behind the curve and they haven't acted quickly enough to begin reversing its policy, then you could see a significant rise in rates.
Rising Rates: Good or Bad News for Investors?
RODILOSSO: In the most immediate sense of the word, rising rates are bad news for fixed-income investors. But there are some reasons why rates may be rising are actually good news for some components of the fixed-income portfolio. Credit, for instance, tends to benefit from economic growth. High-yield in particular is a very pro-growth asset class. While rates might be rising, you may see credit spreads hold in or even have the ability to narrow in some periods of rising rates. For some investors who are in floating-rate instruments, the news is more neutral at this point. A lot of it has to do with the scope and the reasons why U.S. rates are going up. If it is because the U.S. economy is starting to accelerate and can grow at a more modest pace going forward, that may not be such bad news. Finally, from a longer-term perspective, fixed-income investors have been searching for yield for several years. If rates reset at higher levels, at least going forward, fixed-income investors might have a wider array of choices from which to attain yield.
Market Expectation for Fed Policy
RODILOSSO: In terms of Fed policy going forward, the market is expecting the Fed to begin tapering this fall. This means the Fed will scale back the asset purchases -- not necessarily put an end to them immediately -- but to scale back from the $80 billion per month the Fed has been buying in treasury and agency securities. With the Fed’s zero interest rate policy, the market is not factoring in the Fed hiking the Federal funds target until early 2015.
A few things we've learned about the Fed and market expectations of the Fed is one: the Fed has rarely gotten timing perfectly right, and has found itself behind the curve before. Number two: despite trying to be more open about what it's thinking, the Fed has surprised the market in the past with the rapidity of its policy implementation or reversal. As we've learned over the last decade, expect the unexpected.
How Fixed Income Investors Can Position Their Portfolios
RODILOSSO: In a rising interest rate environment, fixed-income investors should think about adjusting their portfolios in several ways. One very important way is to reduce duration in your portfolio. Investors should also think about credit exposure as a way to enhance yield, particularly as they shorten duration. Investors should also think about just simply adding diversification. All markets are unpredictable to a certain degree and there are various asset classes within fixed-income that could react in different and sometimes unpredictable ways to large movements in interest rates. Diversification is always a great tool in order to protect your portfolio.
Duration is a key risk associated with movements in interest rates and that is the first order of business – to reduce duration. As far as credit, credit is a risk. It's something you need to feel you're getting compensated for. For taking on credit exposure, investors are meant to be paid additional yield. In this environment where the U.S. appears to be growing at a modest pace but perhaps fast enough to keep credit markets relatively healthy, some credit exposure may be appropriate.
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