Markets Update: The Fed Decides

Yesterday, members of the Federal Reserve voted to raise rates one-quarter of one percent (25bps). This is an important milestone as it’s the start of what is likely to be a series of interest rate increases. It also marks the Fed moving away from its ultra-accommodative monetary stance that it has held since the beginning of the Covid-19 pandemic by keeping interest rates near zero. The economy has improved enough for the Fed to now focus on reigning in inflation. This is the first interest rate increase since 2018.

The Fed’s Quagmire

As we mentioned in our last update, the Federal Reserve is now facing a conundrum on how to raise rates to quell inflation despite the uncertainty caused by Russia’s invasion of Ukraine. The Fed has signaled that they intend to tighten monetary policy, and we expect them to stay the course. However, their policy path could deviate slightly from expectations. Chairman Powell has indicated that the Fed will be flexible and adapt policy to any adverse changes in the economic climate resulting from geopolitical tensions.

The Fed is seeking a “soft landing,” meaning they will raise rates enough to temper inflation but not too much so as to stifle economic growth. While this goal is challenged by recent inflation pressures, we still expect that the Fed will be cautious in their efforts to withdraw support from the economy and will try to avoid hiking rates more than the economy can handle. They also are likely to begin unwinding their balance sheet this year, which could have the same effect as raising rates.

Rising Yields/Falling Prices

Over the course of the year, we have witnessed a sea change in the fixed income environment that is most notably marked by rising yields. It's a much different market than we have witnessed over the past few years, categorized by record low yields, high prices, and tight credit spreads. Rising bond yields mean that bond prices will drop to compensate for the change in market interest rates. This has caused price volatility among fixed income and interest-rate-sensitive assets.

This is especially true for low coupon and long duration bonds which are more vulnerable to interest rate changes. Over the past two years, we have seen corporations rush to issue bonds at historically low coupon rates – bringing down the average coupon rate of the investment-grade bond index to an all-time low. We are now seeing more than 40% of corporate bonds trading under their par value. This price pressure coupled with rate changes can negatively affect bond funds that hold these assets;?leading to a potential loss of value for these funds.

Our firm's use of individual securities allows us to be nimble during this time. If you have an allocation to fixed income, the individual bond positions in your account will mature in the upcoming years, not decades. By investing in individual bonds, we are able to lock in a set interest rate with minimal market risk when bonds are held to maturity. Additionally, you may own a small strategic portion of preferred stock in your portfolio, which offers higher yields. Although preferred stocks are affected by rising rates and market volatility, it is important to remember that these positions have short to intermediate call dates. The issuer can choose to redeem the outstanding shares at the stated call price. As preferred stocks approach the call date, their price tends to move closer to their call price – depending on the stage of the interest rate cycle this could be either an increase or a decrease in price. The preferred positions we have added to your portfolio are callable at $25.

Outlook

Our firm is well-positioned to take advantage of rising rates. The current scenario has already created opportunities for us to add corporate and municipal bond holdings to your fixed-income allocations. We expect this trend to continue throughout the year. We look forward to adding quality holdings to your accounts and building out your laddered bond portfolios.

We hope this brief update finds you in good health. If you have experienced any changes in your financial situation or have questions for our team, please let us know.

From all of us on the team, we thank you for your vote of confidence in our work!

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