Janet Yellen recently made a highly anticipated speech at the Economic Policy Symposium where it was expected she would provide more clarity on the Fed’s future path on interest rates.
She stated that, “in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal-funds rate has strengthened in recent months.” This outlook moved investor expectations for an interest rate increase before year end from unlikely to likely. It would be the second interest rate increase the Fed has undertaken since holding rates near zero for close to seven years.
We are often asked, “With the potential of another interest rate increase on the way should I be making changes to my fixed income allocation?”
First, we recommend avoiding trying to time interest changes. Pundits and economic forecasters have said time and again that interest rates were on the cusp of a prolonged increase only to see rates remain flat or move lower. Famous fixed income investor Bill Gross made the call in May of 2013 that US bonds had reached their lowest level and would begin to rise. Instead bonds have been flat and fallen further.
Even if the Fed does elect to raise the federal funds rate it’s not a given rates will rise across the board. The Fed increased the Fed funds rate in December of last year and since that time we’ve since the yield on the 10 year Treasury fall from 2.30% to 1.58%. There are many factors that go into determining interest rates. The Fed is not the only factor. In addition, the unprecedented central bank moves abroad, setting interest rates in negative territory has made US interest rates very appealing by comparison. Foreign investors will continue to demand US government bonds providing a headwind against interest rates increasing.
In addition, if a significant shock to the market were to occur, a natural disaster, or terrorist attack for example, or a general negative sentiment for future corporate earnings; investors would likely move to safe haven investments. High quality fixed income and particularly US government bonds are one of the safest investment options. If investors are buying fixed income that keeps rates down and drives up the price.
We view the fixed income side of the portfolio as a source of stability and with a goal of capital preservation. The best way to achieve this is to keep the fixed income allocation shorter term and focused on a high credit quality. A shorter term bond portfolio also has the advantage of being less sensitive to interest rate changes. As mentioned previously keeping a high quality bond portfolio provides a strong counter balance to volatility on the equity side.
By sticking to a fixed income investment strategy designed around the portfolio’s investment goals gives an investor the best chance for investment success over the long term.