Weather forecast, near 100% chance of a rate hike

An examination of U.S. bond fund flow data since the last Fed meeting lays bare recent fixed income trends.

This week the U.S. Federal Open Market Committee (FOMC) will hold its last meeting of the year. And this time it appears likely that it plans to do something it hasn’t done yet in 2016: raise short-term interest rates. According to Bloomberg, the market is currently pricing in a 100% chance that the Federal Reserve (Fed) will raise rates from the current 0.25%-0.50% range to 0.50%-0.75%. The market’s confidence is driven by recent strong economic data. Job gains have been steady and the unemployment rate has fallen to 4.6%, at the same time the Consumer Price Index (CPI) rate is inching closer to 2% after having spent much of 2015 close to 0% (source: Bureau of Labor Statistics). And overall gross domestic product (GDP) grew a robust 3.2% in the third quarter (source: Bureau of Economic Analysis). All of this looks to have given the Fed confidence that it can go ahead and increase short-term rates, and it has clearly communicated this intention out to the market.

What does a rate hike mean to investors?

This potential increase in short-term interest rates probably won’t have much of an impact on most fixed income portfolios. The forecasted move itself is small, and it mostly affects shorter maturity bonds that do not have as much interest rate sensitivity as longer maturity bonds.

Outside the bond market, there will be slightly higher interest rates for some consumer loans like home equity lines of credit and adjustable-rate mortgages. In return we may see slightly higher interest rates on checking and savings accounts. All in all, we believe the impact for investors should not be significant.

Interestingly, if we look at the capital flows for U.S. fixed income exchange-traded funds (ETFs) in the accompanying chart, there has been quite a bit of activity since the last Fed meeting on November 2.

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Although some of the flow activity may be related to the Fed moving closer to raising rates, most of it has occurred since the U.S. election. The new administration has signaled policies such as tax cuts, increased Treasury issuance and reduced regulation that many investors believe could result in higher interest rates, higher inflation and a favorable environment for corporate bonds. Consequently we have seen 10-year Treasury yields rise sharply from 1.86% on November 8 to 2.41% on December 8 (source: Bloomberg data).

Flows since the election have reflected such sentiment. As Treasury rates have risen, investors have pulled back from Treasury securities. At the same time some have moved into TIPs on the expectation of higher inflation. And high yield inflows have been strong on the belief that that sector will continue to perform well. Like EM equities, EM bonds have experienced outflows and poor performance due to concerns about the impact of potentially new U.S. trade policies on emerging economies.

Where should investors go from here?

Investors with shorter-term investment horizons should be cognizant of the impact that rising interest rates have had on their bond portfolios, and be ready for more volatility as the new administration’s policies are implemented beginning in January. But longer-term investors may be best served by sitting tight. Yes, rising interest rates do cause bond prices to fall, and this drags down performance in the short term. Over the long run, however, higher interest rates boost bond fund income payments. Although this may sound counterintuitive, if you are a long-term bond investor, you may actually favor rising interest rates. Higher interest payments may offset the price decline caused by rising rates over time.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, and does not apply to the funds.

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