Aurum Wealth Management Blog

hiking trail markets

On The Hiking Trail

During the previous business cycle, the Federal Reserve raised interest rates 17 times in increments of 0.25%, taking the Fed funds rate from 1.00% to 5.25%.  The committee increased rates at each meeting over 24 months from June 2004 to July of 2006.  While the Federal Reserve controls the Fed funds rate, it influences the bond market.  The following table shows the effect of a rising Fed funds rate on a range of maturities and returns during the last cycle.

This business cycle has been longer, but slower in developing due to the depth of the 2008 financial crisis.  The recovery began officially in June 2009.  The interest rate hiking cycle began in December 2015 when the Federal Reserve raised interest rates 0.25%.  Its second hike came in December 2016 and third one in March 2017.  Each of these was a quarter of a point.

In their meeting on March 15th, the Fed statement included, “The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.”  The median expectations of total hikes for 2017 is three.  However, four of the 17 Fed governors see four hikes this year, with an outlier seeing six hikes.

One of our top managers believes there will be four total interest rate hikes in 2017 and 2018.  Even if one disagrees with the forecast, going through a scenario analysis is worthwhile to prepare for potential volatility which would surprise markets.

The chart below goes back to 1986 with yields on the left axis.  It shows the interest rates of various maturities of Treasury bills and bonds.

Over the past twenty years, the 2-year Treasury bill sits an average of 0.28% higher than the Fed Funds rate.  The bands are wide though, from -1% to +1.5%.  In past hiking cycles, we see tend to see this difference decline.  The same goes for other maturities.  Arguably, if the Fed Funds tops out at 3%, the curve will converge around those levels.

The Fed’s latest dot projections puts its terminal Fed Funds rate at 3%.  If past is any prelude, interest rates across maturities should converge around this Fed Funds level (which occurred in 1989, 2000, and 2006 as shown in the pink circles above).  Given the current projections, the timing would be approximately 2019.  This would be a point of value for possibly extending maturities for bond investors.  It would also be a sign of trouble for the economy, as a flat or inverted yield curve typically precedes a recession.

The good news is that we are quite a bit away from that sign coming to fruition.  Broad economic conditions are positive; consumers are spending and businesses are confident.  Positive fiscal policy expectations are outweighing any negative effects from higher interest rates.

We think investors should have an above average weight to floating rate assets in bond portfolios today.  This does not mean just bank loans, which are junk-rated (or the more palatable name, ‘high yield’).  It means investment grade quality assets as well.   The key is bonds with yields that will float higher with the interest rates hiking higher, such as asset-backed securities.   In addition, several of our managers have currency trades which express the expectations of higher bond yields.  Avoiding short duration funds holding fixed rate assets in the two to five-year area of the curve seems wise.  This is the area of the yield curve highly affected by rising interest rates.

There is plenty that could evolve differently over the next two years.  Inflation expectations could fall greatly if the tax and stimulus bills are not passed.  Janet Yellen’s term as Chair of the Fed ends in January 2018 and it is unlikely that she returns for another.  As always, there are plenty of unknowns… and then there are also “unknowns, unknowns.”

Going through this exercise frames expectations in case the facts change.  As Sir John Maynard Keynes said, “When the facts change, I change my mind.  What do you do sir?”

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

This entry was posted in Aurum Wealth Management, Mailchimp RSS and tagged , , , , , , , , , . Bookmark the permalink. Follow any comments here with the RSS feed for this post. Comments are closed, but you can leave a trackback: Trackback URL.
© Copyright 2017 Skoda Minotti | Privacy Policy | Disclaimer | Remote Support
Cleveland 440-449-6800 | Akron 330-668-1100 | Tampa 813-288-8826
Website designed and developed by Skoda Minotti Strategic Marketing