The Fed’s Latest Move

The Fed raised rates again. Still, there may be some opportunities in bonds.

After just two rate hikes in nearly a decade, the Fed raised rates again at the March meeting. Citing moderate growth in economic activity, solid job gains, and increased inflation, the Fed pushed its key borrowing rate up 25 basis points higher. The federal funds rate target range is now 0.75%-1.00%.

The economy by all appearances has made really good progress: Job gains have been quite solid, and the unemployment rate is now in line with the Fed’s estimate of normal long-term levels. Meanwhile, inflation continues to rise toward the Fed’s target of 2% a year.

What was less certain entering the meeting was how much the Fed’s expectations for the path of future rate hikes had changed. When we look at the survey of Fed officials rate forecasts, known as the “dot plot,” there was little change. The median expectation was still for two additional quarter-point hikes in 2017, and three in 2018, though there was a slightly higher expectation for 2019.

The Fed also indicated a willingness to let inflation rise slightly above the bank’s 2% target. Overall, it appears to be pretty consistent with market expectations going into the meeting.

This year’s rate hikes are already built into bond yields. And while retail investors may worry that a rising rate environment is bad for bonds, they should keep in mind that the Federal Reserve doesn’t control the entire yield curve: Changes in the federal funds rate most directly affect the short end of the curve, or shorter maturity bonds. When the Fed raises rates, it pushes up yields on short-term bonds. But yields on 10-year bonds, for example, can be affected by a whole host of other factors, including risk sentiment, expectations for inflation and economic growth, and investors’ demand for longer-maturity securities.

Put simply, the long end of the yield curve doesn’t always move in sync with the short end, so the Fed’s rate increase may not cause prices to fall on longer-term bonds. What’s more, longer bonds can provide yield as well as protection in the event of a flight to quality that causes stocks and other, riskier assets to underperform.

We think the key is to owning bonds is having a flexible mandate whereby you can obtain attractive yields from various segments of the bond universe.  This may include government bonds, corporates, preferred securities, floating rate securities and inflation protected bonds, to name a few.  This reduces the pure interest rate sensitivity of your overall portfolio.

Source: Fidelity Viewpoints