Happy Summer Solstice! We hope you have enjoyed the long and warm days leading us into summer, and that you continue to maximize time spent outside and with loved ones during one of the most enjoyable seasons of the year. For our latest edition of The Bottom Line, I will address the recent interest rate hikes by the Federal Reserve, and how they might affect your investment portfolio.
On June 14, the Federal Open Market Committee increased the federal funds rate by 25 basis points, to a range of 1.0 to 1.25%. The Fed made similar increases in December 2015, December 2016, and March 2017, after seven years of near-zero rates that began with the Great Recession.
The most recent rate hike should not come as a surprise. Chairwoman Janet Yellen has been setting expectations that the Fed would slowly raise rates as long as the economy continues to improve; her key criteria include low unemployment and stable inflation.
Recent reports of inflation came in at 1.9%, slightly below the Fed’s stated 2% target, but other data was more convincing. With unemployment falling to 4.3% in May, the lowest level since 2001, and economic expansion reaching its ninth year, the Fed seemed comfortable that conditions were right for another rate hike.
While we appear to be in a period of rate increases, the overall level of rates (1.0% to 1.25%) is still near 60-year lows. The magnitude of the rate hikes is also low; according to JP Morgan, during the last 5 periods of rate hikes since 1980, we saw the Fed raise rates an average of 9 times over 14 months. During this rate hike period, illustrated in the last box of the chart below, we have seen only 4 rate increases in the last 18 months.*
Effects on Client Portfolios
Rising interest rates typically have a negative impact on bond investments as bond prices fall with rising yields (interest rates). Because interest rates have gone up so slowly this cycle, however, we have not observed a markedly negative effect on our client bond positions. This is due in part to the persistently low rates among longer term bonds. For example, the yield on the 10-year Treasury note fell below 2.2% last week, hitting a low for the year.
Will the Fed continue to raise rates and how will this affect your portfolio? Many Fed watchers predict at least one more hike this year, but that will depend on the extent that the economy continues to improve. Next year we may also see a continued approach of very gradual rate increases.
While there may yet be losses from bond price declines, the higher yields resulting from rising rates generate greater income for bondholders. Also, bonds act as an important source of stability during volatile periods in the stock market, providing important downside protection during periods of stock market weakness.
In terms of the stock market, stocks have risen in some rate hike periods and fallen in others, with an average gain of 3% over the last 5 rate hike periods. Rising interest rates have not hindered performance during this particular rate hike period, with the S&P up over 20% in the 18 months since the Fed started raising rates in December of 2015. The fact that we are still at historically low levels of interest rates has proved to be beneficial for stocks during this cycle.
Lastly, it’s important to remember that one of the reasons stocks and interest rates are going up is that economic growth is strong enough that rates do not need to be held artificially low by the Fed. While we will closely monitor the Fed’s actions going forward, we have not been alarmed at by their efforts at normalizing interest rates so far.
If you have questions on this topic or anything else, please let us know. Thank you.
*Source: JP Morgan, Guide to the Markets. Data also from Morningstar as of 6/15/17.