Q&A: Our Views on the Fed’s Rate Hike

Q: The Federal Reserve (the Fed, the U.S. central bank) just raised its short-term interest rate target for the first time since 2006. What’s your take on this?

A: It’s important to emphasize that this rate hike and the potential rate hike cycle we might be entering can’t be compared apples to apples with past Fed rate hikes, for several reasons:

  • We’re starting from an unprecedented low level of interest rates, far below historical “normals” and averages.
  • We just experienced a weaker, more-extended, more-fragile-than-usual economic recovery from the last recession, in 2007-09, which was extraordinarily deep.
  • Inflation is low in the U.S. economy, and deflation is a greater threat than inflation in the global economy.
  • The size, composition, and mechanisms of the bond and money markets have changed considerably since the last time the Fed raised rates.

Download a PDF of this post: Our Views on the Fed’s Rate Hike

We’ll revisit and reemphasize some of these points as we go along. In the meantime, we believe we can put this rate hike in the proper broad perspective in just three bullet points:

  • It’s small, just 25 basis points (bps—1 bp equals 0.01%), from a very low base. We’re starting from near 0%. Even with this small increase, short-term interest rates remain low and very accommodative in the U.S., from a long-term historical perspective.
  • It was well-communicated; no surprises. The Fed has telegraphed a possible rate increase for most of this year. In fact, we believe that the Fed could have (and should have) started the rate normalization process earlier than it did.
  • It was heavily anticipated by the markets—they’ve already adjusted significantly.

Q: How have the markets adjusted?

A: Many of the big market moves and much of the accompanying volatility that have already occurred this year can be attributed to Fed rate hike expectations. For example, expectations of higher short-term interest rates made the U.S. dollar relatively attractive compared with currencies from economies with lower interest rate prospects, so the dollar rallied. The stronger dollar affected commodities priced in dollars, reducing demand, which contributed to their price decline. Lower commodity prices affect commodity exporters, particularly emerging markets (EM), which has contributed to EM volatility.

And last but not least, the U.S. Treasury note yield most closely linked with Fed rate policy expectations (the two-year Treasury note yield) has risen significantly in the past two months, more than yields for longer-maturity U.S. Treasury securities. This has resulted in a significantly “flatter” U.S. Treasury yield curve—the yield difference between shorter- and longer-maturity U.S. Treasury securities has decreased. Flatter yield curves are typically associated with periods of economic uncertainty, such as what we’re experiencing.

Q: Will the markets adjust further?

A: That depends on the size and pace of the Fed’s interest rate increases going forward, and how the economy and investor sentiment respond. If the Fed keeps raising its short-term interest rate target, the U.S. Treasury yield curve will likely flatten further. Other markets will respond accordingly, depending on what happens with economic growth, inflation, currency movements, etc. No one can really say for certain. We’re entering an uncertain, potentially volatile period.

Q: How do you think the Fed will proceed with further interest rate hikes?

A: We expect small rate hikes spaced at intervals—“fits and starts.” We believe the Fed will move in 25 bps increments, spaced according to how the economy and capital markets respond. In the Fed’s own words, “…the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

Following up on our flatter yield curve/economic uncertainty comments, current economic conditions do not call for big, frequent U.S. interest rate moves at this time. The U.S. and global economies still face significant headwinds, with various economic indicators sending conflicting signals. On one hand, U.S. employment, wages, rents, home prices, and consumer spending seem to be improving. But on the other, manufacturing, corporate earnings, and commodities look like they’re struggling, and inflation is very low, especially when viewed from a global perspective.

Q: If global inflation pressures are low, why did the Fed choose to raise interest rates now?

A: We believe the Fed wants to start normalizing U.S. interest rates sooner rather than later. One of the four key themes we’ve highlighted for the past 15 months has been normalization—U.S. and non-U.S. central bank policy has been abnormally accommodative since the 2008 Financial Crisis and Great Recession.

This accommodation helped stabilize the global economy and capital markets, but the resulting historically low interest rates punished savers and rewarded risk-taking behavior, increasing the odds of financial market bubbles. The longer central bank policy stays abnormally accommodative, the greater the future risks of bubbles and other imbalances, including inflation. We think the Fed believes that by moving now in relatively small increments at a modest pace, it can avoid bigger, more concentrated moves later that might be more disruptive for the economy and capital markets.

Q: What about the other major central banks, particularly the European Central Bank (ECB) and the Bank of Japan (BoJ)? Will they follow the Fed?

A: Not any time soon, from our perspective. In fact, the ECB and the BoJ appear to be headed in the other direction, toward increased or continued heavy monetary accommodation. This illustrates another of our four key recent themes, global divergence, which describes diverging economic growth and central bank policies between the U.S. and the rest of the world. The U.S. has reached a different stage in the economic cycle than its major developed country peers. Sustained, moderate U.S. growth has allowed the Fed to end its bond purchase program (quantitative easing, QE) and start raising interest rates.

Conversely, while still facing deflation threats, the ECB has significantly increased its monetary accommodation this year, especially QE, resulting in negative bond yields in Europe. The ECB could increase accommodation further in the months ahead. Meanwhile, Japan has suffered two consecutive quarters of negative economic growth, forcing the BoJ to maintain low interest rates and heavy QE. The only major central bank, other than the Fed, that’s likely to raise interest rates in 2016 is the Bank of England, but even it still appears to be months away from that move.

Q: Where do you see opportunities in this environment?

A: We like to answer this question in the framework/context of two other recent themes we’ve been highlighting:

  1. Volatility, as markets normalize, and
  2. Opportunities for active managers to add value with security selection in volatile markets.

We believe interest rate normalization will trigger additional market volatility and higher levels of investment risk. But higher volatility and risk can also translate to higher potential returns in certain sectors. These sectors offer opportunities where market experience and expertise can translate into successful security selection if a favorable entry point is chosen in terms of price and market conditions.

For example, the energy sector has been battered this year by the collapse of oil prices, reducing valuations significantly across a wide spectrum of energy companies. But we believe some companies are better positioned than others to potentially rebound from these low valuations. Our analysts in our value discipline have identified integrated oil companies whose business models we believe will allow them to withstand near-term challenges while remaining well positioned for a rise in crude oil prices. Our equity analysts have also identified opportunities in the financials sector, where profitability has been hampered by low interest rates. Higher rates could help these companies. Furthermore, the strong dollar, relatively low interest rates, and low energy prices should support consumer-related sectors in the U.S., including restaurants, travel, retail, and home improvement.

In fixed income, where credit sectors have been volatile this year, we see opportunities in high-yield corporate bonds, particularly among oil and gas pipeline issuers. We also like European bank bonds, which stand to benefit from the ECB’s continued, and possibly expanding, QE.

Q: You’ve mentioned some specific sectors and industries. What about broader investment shifts or adjustments?

A: Since 2008, unusually accommodative central bank policies muted risks and encouraged investors to increase their risk exposure. We believe many investment portfolios may still reflect that environment, with elevated exposure to more aggressive assets. If the U.S. maintains a path of progressively less-accommodative monetary policy, we expect market risk to continue its return to more normal, longer-term two-way levels. Under those conditions, it’s appropriate to ask if portfolios are balanced and positioned to withstand potentially greater volatility and dispersion of returns, which we’ve already seen in the stock and high-yield bond markets.

We are encouraging investors to review their portfolio positioning and make sure they are comfortable holding those positions through what is likely to be a more volatile environment. We suggest that investors stay well diversified, keeping or building upon core positions in high-quality issuers that can most readily withstand the coming volatility and higher interest rates.

Q: Rising interest rates (and rising interest rate expectations) typically have a significant impact on the bond market. What’s your bond outlook?

A: Our outlook ties back in part to how we started this Q&A—we’re not facing a typical Fed rate-hike scenario. Inflation is not an immediate threat. The manufacturing sector is struggling. U.S. economic growth is moderate, not robust. Short-term yields are poised to rise further if the Fed keeps raising rates. But we don’t believe intermediate- and longer-term yields will soar until the economy picks up steam and/or inflation becomes a bigger threat. So we like the intermediate-to-long end of the yield curve in this environment. Rising short-term rates could help contain inflation and slow the economy, which are favorable for intermediate- and longer-term bonds. We’re keeping the duration (price sensitivity to changes in interest rates) of our bond portfolios at neutral, rather than shortening them (making them less sensitive to interest rate changes), as might be expected in a more typical rising interest rate environment.

Q: What’s your stock outlook—U.S. versus non-U.S.?

A: Current conditions could make non-U.S. stocks more attractive. Reduced monetary stimulus, higher interest rates, and a stronger dollar in the U.S. combined with increased/continued stimulus and lower interest rates in non-U.S. economies could help create more favorable conditions for companies in non-U.S. markets. Japan’s stock market has been a market leader year to date, for example, and European stocks enjoyed a strong rally earlier this year when the ECB increased its QE.

Q: What about market capitalization and investment style?

A: There isn’t a simple answer to that question because performance varies over time with economic and market conditions. This is why we advocate diversification by geography, size, and style. So while it is difficult to say definitively which cap size or investment style performs best for a given set of circumstances, we can say that performance likely depends on which economic growth path we end up on. Consider these two possible scenarios as interest rates rise:

  • Mid- to late-cycle economic expansion: This typically favors growth. Companies with higher earnings growth rates would likely see greater stock price appreciation, even if price to earnings (P/E) ratios remained the same. This environment may also favor smaller companies, which have historically had higher growth rates.
  • Recession, recovery, and early-cycle expansion: This has historically favored larger, value-oriented stocks as earnings growth likely slows and P/E ratios for high-growth companies begin to compress. In this environment, investors would be less willing to pay a premium price for companies that experienced a slowdown in earnings growth.

Regardless of size and style, we believe fundamental cash flow and balance sheet analysis will matter more in the U.S. stock market in 2016 than it did during the last few years. The Fed’s QE and low interest rates compressed return differentials and made much of the market trade together in the same direction. Now, with the Fed’s market management mantle lifting, conditions are normalizing and individual stocks are trading more on their own merits, opening a window of opportunity for active managers with security selection skills.

To learn more about rising interest rates and how it might impact your investments, watch our video:

“Rising Interest Rates – The Reality and What to Do”
Individual Investors | U.S. Investment Professionals

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Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.

Diversification does not assure a profit nor does it protect against loss of principal.

The opinions expressed are those of G. David MacEwen and Victor Zhang and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice.