Federal Reserve Chairwoman Janet Yellen made quite an impression at her inaugural press conference when she indicated that interest rates could begin to rise no sooner than six months after the Fed's asset purchases end. But, perhaps of greater interest were her statements making clear that U.S. inflation has replaced unemployment as the primary factor she will consider when choosing the specific timing of the first increase in interest rates. Now, financial markets are getting more sensitive to inflation expectations and announcements. While investors will likely debate ad nauseam the level of inflation, which will compel the Fed to act, the timing of hiking the federal funds target rate will depend largely on the balance of power between Fed hawks and doves. The hawks believe policy must stay ahead of inflation for fear of losing control and having to raise rates even higher, while the doves are unlikely to act until they can see the whites of inflation's eyes. In reality, the slow progress toward the Fed's 2 percent inflation target could see the whole debate being deferred late into 2015 or even the beginning of 2016. History, as shown in the chart below, suggests that equities should outperform fixed-income assets in the year leading up to the eventual rise in interest rates.
The Fed's "dots" chart anonymously plots where Fed officials believe short-term rates will be over a three to four-year horizon. Today, the majority of dots predict a longer-run federal funds target rate of 4 percent or above, with some dots reaching 4.5 percent. Historically, as the Fed raises rates, the Treasury yield curve becomes flatter, and in time, the 10-year U.S. Treasury yield drops below the fed funds rate. So, if the "dots" are correct, and the fed funds rate is headed to as high as 4.5 percent, it is possible that the 10-year U.S. Treasury note will reach 4-4.25 percent.
This means that floating-rate assets, particularly bank loans and collateralized loan obligations, will likely continue to outperform. Flows into bank loans should continue as interest rates rise and there is likely some spread tightening left in the sector. The bad news is that securities in the three to seven-year area, called the belly of the curve, will likely underperform. Credit spreads should not start to widen until we see an increase in defaults, which start to tick up usually about one to two years after the Fed begins to tighten. So, even if you believe Dr. Janet Yellen will begin raising interest rates in 2015, credit spreads are unlikely to meaningfully widen until late in 2016 or 2017.
U.S. Equities Outperform in 12 Months Before Fed Tightens
Federal Reserve Chairwoman Janet Yellen has made it clear that she could raise interest rates as early as June 2015, although we do not see that as likely. During the 12 months before a Fed tightening cycle begins - a period we could now be entering - U.S. equities have typically outperformed fixed income by a wide margin. In the last five periods leading up to Fed tightening, the S&P 500 has gained 22 percent on average in the year before the Fed began raising rates, compared to 4.2 percent or less for fixed-income assets.
PRICE PERFORMANCE DURING THE YEAR BEFORE FED TIGHTENING*
Source: Credit Suisse, Barclays, Bloomberg, Guggenheim Investments. Data as of 3/31/2014. *Note: Average price performance in the 12 months prior to Fed tightening cycles in 1983, 1986, 1994, 1999, and 2004.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.