With the increase to the federal funds rate in December, the Federal Reserve has embarked on a policy of monetary tightening for the first time in 10 years. Given the uncertainty in the global macroeconomic environment, however, many investors are trying to anticipate the Fed’s future course of action.
Can the Fed continue to tighten?
Entering 2016, the market had already begun to discount a slower pace of rate increases than the Fed was projecting. As market turmoil surged in January and February, market commentators discussed whether the Fed would be able to raise rates even once more in this cycle without adding fuel to the fire of market volatility.
For investors pursuing income-oriented strategies, there is a lot riding on whether the Fed continues to lift rates, and at what pace. When rates rise, it can cause losses for portfolios with excessive interest-rate risk. Strategies for navigating rates can help offset this risk.
When history might not be a guide
Like any institution, the Fed needs to preserve its credibility, which may make it reluctant to completely retreat from rate increases. In the last three rate-tightening cycles over the past two decades, the Fed’s course has involved multiple increases. Short-term rates rose by an average of 3%.
Clearly, the Fed is looking at a different set of challenges today than in previous tightening cycles, making a sustained, steady path of rate increases much less likely.
The volatile 10-year yield
Note the low level of the 10-year Treasury yield in mid 2012. Since then, inflation and growth have remained modest, yet the 10-year Treasury yield has remained volatile with a very slight upward trend.
We think there is enough uncertainty ahead to keep benchmarks such as the 10-year Treasury volatile. That’s why we have advocated for investors to be prepared with an active, flexible approach to interest-rate risk in their portfolios.
Strategies with tools to reduce a portfolio’s interest-rate sensitivity, as measured by duration, can be helpful supplements to an income strategy in the market conditions ahead.
Have flexibility to maneuver
One thing is certain — the Fed will continue to review incoming data as it decides its next policy steps. In setting a portfolio strategy, it’s important to consider many perspectives on the implications of evolving data as the Fed charts its future course.