What Investors Need To Know About Rising Rates

Includes: GOVT, PLW, TRSY
by: Matt Tucker, CFA

When new Federal Reserve Chair Janet Yellen communicated the Fed's view on markets after the March FOMC meeting, she left some investors feeling a bit uneasy. Now that the dust has settled, I wanted to reiterate that while the Fed is maintaining its original plan to continue to reduce its bond buying program, when and how the Fed might start raising the Fed Funds rate remains unclear. In particular, the Fed communicated new information on both the timing and drivers of an interest rate movement that bear closer scrutiny.

The Timeline Shift

Until Yellen's press conference comments, the Fed had not given any specifics on when it would implement a short-term interest rate hike, stating instead that it would hold short-term rates low for a "considerable time" after it ended quantitative easing (QE) purchases. During the press conference, Yellen provided guidance that "considerable time" was about 6 months. This gave the market a much more firm date for rate hikes, and on the news, bonds immediately began to price in this new information.

New Economic Indicators to Watch

In previous meetings, the Fed had indicated that they were focused on the US economy attaining full employment, and that an unemployment rate of 6.5% was being used as an employment goal. Unemployment is now 6.7% and there was some question about what the Fed would do if they hit its employment goal, but we're not yet seeing broad economic growth it was hoping for. To address this, the Fed indicated it would focus on a range of statistics including labor market measures, inflation and other financial developments. This will give the Fed more flexibility in assessing the overall health of the economy and taking appropriate action.

In anticipation of rising rates, investors have piled into floating rate debt and short duration funds in the past year and a half. As Fed policy shifts, it is prudent for investors to adapt their approach as well. Going forward investors should keep three things in mind:

1. Beware the middle of the yield curve. As my colleague Russ Koesterich notes in a recent Blog post, we are practicing caution within the short to middle part of the Treasury curve and are underweight Treasury bonds with three- to seven-year maturities. This is where the market is re-pricing new Fed expectations and we expect volatility here in coming months.

2. The tails of the curve may provide more value. While the name of the game in 2013 was shorter duration, investors should be well suited to take a more nuanced approach to interest rate management now. Very short maturity bonds may be less impacted by Fed policy in the near term as it appears that we are still some ways off from the Fed actually raising interest rates. Additionally, longer maturity bonds have actually done fairly well in 2014 and we expect will still offer some value going forward as they tend to be more impacted by changes in economic growth and inflation, neither of which appears ready to spike in the near term.

3. Consider tax-exempt munis and emerging market debt. We are currently overweight munis due to strong credit fundamentals and are neutral to emerging market (EM) bonds overall. I explored the current EM debt landscape in a recent Blog post and you can find it here.

In my next post, I will take a closer look at how the Fed works, focusing on how it reaches a consensus, and what this means for the end investor.

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