I know. I know. Everyone’s tired of even thinking about a possible rate hike when the Fed meets on September 20. We’ve been going down the same road, for so long, that it seems almost inconceivable that Janet Yellen and the Fed will actually increase interest rates. And despite Yellen’s Jackson Hole speech stating that the case for a rate increase has “strengthened” in recent months, she also makes it clear that the decision is still on the table. Clearly the mystery won’t be solved until September 20.
But what if the Fed does raise rates? Are your clients’ fixed income portfolios prepared?
The skepticism surrounding a hike isn’t unfounded. After all, the list of events driving global economic uncertainty is long. Brexit. Terrorist attacks in France. The earthquake in Italy. The China “slowdown”. Plus, the US economy is still growing at a sub-2% annual clip. And yet, despite all these factors, many analysts are saying this may be the time when rates finally get a hike. The market itself is weighing in: the CME Group 30-Day Fed Funds futures are signaling a 79% chance of a 0.25%-0.50% hike at the September meeting. To understand the thinking behind those numbers, let’s take a look at the two main indicators of a hike in interest rates: inflation and GDP.
Inflation on the rise
Here’s the main reason I (and many others) think a rate hike may be in the cards: Inflation is increasing—and increasing more than many people think. Core inflation, which is the consumer price index (or “regular” inflation rate) excluding the food and energy sectors, has been running above the Fed’s target rate of 2% for the past 9 months.
The recent Bloomberg article “Inflation isn’t dead; it just might not be where you think it is” highlights the vast discrepancies between rates of inflation for various goods and services. Many of the basic things we need to live have high inflation rates. In the past 20 years, food is up 64%, medical care 105%, childcare 122%, housing 61%, and college education a whopping 197%. At the same time, many discretionary items have experienced significant deflation. TVs are down 96%, toys 67%, and wireless service 45%. Clearly the current level of inflation is made up of wildly divergent categories of prices, and a change in the mix can quickly drive the overall level of inflation up or down, making defining the “real” inflation challenging indeed.
The second primary metric the Fed looks at when judging whether market conditions warrant Fed interest rate action is “real GDP” (or GDP adjusted for inflation)—a measure that has failed to meet the Fed’s 2% annual target for the past three quarters. However, this target threshold has been met or exceeded in 6 of the last 9 quarters. While some see a recent trend of strengthening, just as many see a long slow decline driven by many of the macroeconomic conditions mentioned above, as well as an aging workforce and other demographic factors.
So have the Fed’s “2 and 2” conditions of core inflation and real GDP growth been met? And if they haven’t been met statistically, are they close enough to warrant an increase later this month? Nobody knows—but whatever the decision, now is a good time to consider the impact a “yes” vote may have on your clients’ portfolios.
Today is one of the “cheapest” times to adjust fixed income portfolios
The longer the duration of a fixed income instrument, the more its price changes in the face of a change in interest rates. This means that positioning your clients’ fixed income portfolios generally means reducing duration. Even if you are not convinced rates are going to rise, now is a good time to consider reducing durations, largely because it’s currently pretty cheap (more about that in a moment). So instead of longer-term maturities—say 7 to 10 years—you may consider moving to a shorter duration of 2 to 3 years. While every strategy is dependent upon the client’s individual situation, generally speaking, shorter is better when rates are rising. Here’s why:
The US Treasury yield curve is currently very flat, meaning that the difference in yield between the various maturities is not that great by historical standards. With that in mind, you can shed some duration in your clients’ portfolios without giving up much yield. For instance, the spread between the 2-year yield and the 10-year yield is currently around 0.80%—0.68% lower than a year ago and significantly less than half of where it was two years ago. (Incidentally, today’s relatively flat yield curve is yet another sign that the fixed income markets are anticipating a Fed rate hike.)
If you’re guilty of tuning out any news of a hike, you’re not alone. “Normalcy bias,” as it applies to interest rates, is a very real effect that influences us to assume that the current low rate environment will persist indefinitely. The Fed’s lack of action has fueled this bias. But as September 20 looms, don’t let complacency take hold. The Federal Reserve Board just may decide September is the perfect time to initiate a rate hike, or even begin a series of hikes.
With all this in mind—inflation on the rise, real GDP growth, flat yield curve—now may be an ideal time to get ahead of the curve and position your clients’ fixed income portfolios for higher rates by shedding some duration.