Federal Reserve and Rates

In my GDP and Recessions article we reviewed how in 2019 it was the first time the yield curve inverted since 2006 and typically, when the yield curve spread falls below .50, GDP declines the economy falls into a recession. We anticipate the yield curve ratio to fall through the .50 threshold at the end of the second quarter of 2020.   

In 2019 the Federal Funds interest rate started to trend downward. The Fed Funds Rate is the interest on bank excess reserves held at the Federal Reserve. This rate sets the tenor for determining short-term interest rates in the United States. From the end of 2015 (.12%) to the middle 2019 (2.42%), the Fed had been implementing a monetary policy that focused on tightening in order to lower the growth of money supply and available credit. Since 1965, the Fed has watched over six rate-hike periods that have lasted on average 46 months. Markets are generally anticipatory, and will react to central bank efforts to combat inflation, recession and unemployment. However, given the current prospective trend, a return to lower rates, investors should prepare their portfolios so they can be responsive to the changing environment while looking for yield.

As bond prices move in the opposite direction of rates, long-term bonds are more sensitive to rate moves, as their duration tends to be longer. Portfolios with longer duration tend to be more sensitive and volatile than those with shorter duration, and the current low interest rate environment increases this risk. For example, a fund with a five-year duration would be expected to lose 5% of its net asset value if interest rates rose by one percentage point, or gain 5% if interest rates fell by one percentage point. Therefore, lowering portfolio duration may lower interest rate risk for investors. Investors should consider utilizing short-term investments such as short-term bond funds and ultra-short bond funds. It’s important to know, of course, that short-term investments also carry lower yields and investors should balance yield needs with the focus on lower-duration investments to lower overall interest rate risk. Investors should also consider investments in nontraditional bond or fixed income portfolios that have low duration while delivering a competitive yield.

The Fed keeps a close eye on how fast the economy is expanding because the pace of growth is crucial to its two goals: maximum employment and stable inflation (target 2%). The Fed Funds Rate, the central bank’s preferred policy tool in recent years, is a benchmark for many consumer and business loans. Lowering the Fed Funds Rate is typically done to stimulate the economy and to help provide certainty to investors. These steps are designed to pressure the long end of the yield curve lower. Lowering long-term rates will help bring down the cost of borrowing for corporations, helping them to fund long-term projects, add to working capital and pave the way for future economic growth.

In 2019, the global economy was slowing as manufacturing activity weakened, and political tensions surrounding the trade war with China created uncertainty. That slowed down investment, which could hold back GDP growth. Against that backdrop, countries around the world cut their borrowing costs and some regions rolled out a broader package of monetary stimulus.

In May 2019, the Fed started a policy to trim the Fed Funds Rate. This left many pundits scratching their heads since unemployment is low, wages are rising and households are spending. Since 1969, once the Fed has initiated a policy, we have seen the rate drop on average 72% over 42 months. Each time such a policy was enacted, the economy was either in a recession or a recession occurred during the rate-lowering period. The Fed focus is on the U.S. consumers who currently power about 70% of the U.S economy. The movement toward a lower Fed Funds rate was designed to keep the American economy humming along. Unfortunately, once the Fed enacted this policy, longer-term bonds started trading at interest rates that were lower than those on short-term securities. This is known as the yield curve inverting. It’s an unusual occurrence that typically happens before recessions, and one that could signal that investors have become pessimistic about the economic outlook.

As the Fed strives to strike the right balance with its monetary policy, investors may seek out nontraditional bond solutions and other income-oriented investments that have the potential to perform well whether interest rates are rising, flat or falling. Individual strategies within the nontraditional bond fund category vary greatly, and investors seeking a fixed income alternative would be well served to consider each strategy based on its unique merits, such as correlation to traditional fixed income benchmarks, before making an allocation. Achieving a competitive yield will continue to be a challenge for income- oriented investors.

The table below illustrates how asset classes have responded to short-term rate moves. We expect that short-term rates will continue to decline based on the policy that the Fed enacted in 2019. The biggest driver for that trajectory will be inflation and growth of the U.S. economy.

The focus is likely to be on interest rates and fixed income fundamentals in 2020. Given that the reinvestment of dividends plays a prominent role in an investor’s cumulative portfolio returns, the search for yield will remain a prominent theme in 2020. Again, investors may benefit from moving beyond traditional fixed income strategies. Investments that incorporate global, diversified sources of income—along with opportunities for capital appreciation from a mix of other yield-producing asset classes—may be worth strong consideration. Even if short-term and long-term rates stay range-bound for an extended period, investors should be looking for nontraditional fixed income strategies that can adapt to this challenging rate environment.

5