An economist and a portfolio manager discuss the factors the U.S. Federal Reserve may be considering as it decides when to raise interest rates.
Matt Miller: One of the big topics on people’s minds this year is the Federal Reserve has talked about starting to normalize and introduce a first rate hike, perhaps later this year. What’s your sense of where Janet Yellen and Fed are headed, and what will the impact be once we enter this new world after having had interest rates near the zero bound for so long?
Wesley Phoa: I think the Fed would very much like to get away from the zero bound as soon as they prudently can, and it would make all the sense in the world for them to move late this year. Even right now we’re looking at an unemployment rate which is fairly close to full employment, inflation is moderate but quite stable and there is no reason to believe that a modest raise in rates would affect business decisions a whole lot. So why not go ahead?
I think the thing that they have to weigh is that the financial markets over the last five years or so have become very, very sensitized to what the Fed says and does. So the risk of moving is that they’re going to trigger volatility in asset prices in financial markets. But that’s, I think, something we’ll just have to live with. It’s better than staying at zero for too long and having other kinds of problems build up.
Matt Miller: In general in the bond market, Wesley, what, what can investors do to cope with the impact of rising rates?
Wesley Phoa: I think of rising rates as a mixed blessing for bond investors, because you’re taking a hit to the net asset value of your holdings. But on the other hand, bonds are constantly paying coupons. They’re constantly maturing. Mortgages are constantly giving you prepayments. You’re reinvesting those all the time. And the advantage of rising rates is that you get to reinvest at more attractive yields. Over the long run that helps you, helps you a lot.
So there’s nothing wrong with rising rates. You can see bonds posting decent returns and serving their function as the kind of stable anchor of [your] portfolio. As rates just naturally go up and down through the economic cycle, what makes rising rates very awkward is if it happens very suddenly, very disruptively. That’s a much bigger problem.
Darrell Spence: I would say the violent moves in interest rates that Wesley is alluding to have generally been associated with periods of much higher inflation. So admittedly, if you look back at all past Fed tightening cycles, the pattern is for long-term bond yields to drift upward. It’s actually been very consistent through pretty much every single cycle. How much they drift upward really depends. But what causes the types of moves that can be disruptive, say, to the equity market have generally been associated with inflation, and that’s certainly not what we see happening in the current tightening cycle that’s likely to kick off later this year.
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