By Gregory S. Kaplan, CFA

Fed_Building
  • Fed may delay next hike after soft inflation readings; hurricanes
  • Key for investors is not timing of hikes but where rate winds up
  • “Barbell” portfolio strategy indicated as yield curve flattens

In a note to clients earlier this year, we made the case that interest rates would move modestly higher in 2017. Our expectations have proven correct on the short end of the yield curve, although yields on the long end have been lower year-to-date. Bonds have performed well as the market lowered the odds of meaningful fiscal stimulus, a key driver in expectations for faster GDP growth and higher rates.

Nevertheless, the economy has remained stable and growth shows signs of accelerating. With inflation expected to edge higher, unemployment heading even lower, and tax cuts still on the table, we are expecting yields across the curve to edge higher as well.

Although the market is now pricing in a greater than 50% probability of another interest rate increase in December, we think the Fed is more likely to delay due to continued softness in inflation and disruption in the economic data from the two hurricanes that made landfall in August and September. Risks to this forecast lie in the recent hawkish shift of the FOMC and the easing of financial conditions in spite of Fed rate hikes (see chart). 

3Q17-Kaplan Chart 1 - 450px

The exact timing of the next increase is less important to financial markets than the Fed’s forecast for the Fed Funds rate at the end of this hiking cycle. This “terminal rate,” sometimes called the neutral rate, has migrated lower throughout the current expansion and reset another quarter-point lower, to 2.75%, at the FOMC meeting in September (see chart). The neutral rate is the Fed Funds rate that is neither stimulative nor restrictive to economic growth with stable inflation.

What does this mean for investors? Even though the Fed is expected to continue tightening monetary policy and raising short-term rates, longer-term rates are likely to be contained. This suggests that a barbell strategy – investing in long and short duration bonds but underweighting intermediate duration issues – is still preferred so as to take advantage of the flattening yield curve. We also may see longer duration assets surprise with continued solid performance. 

IMAGE_QU 3Q17-Kaplan Chart 2 - 450px

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.

The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.

The Standard & Poor’s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund’s performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.