Although the timing isn’t entirely clear, it is very likely that the Fed is going to raise short-term interest rates sometime this year. Just last week, the Fed dropped the word “patient” from its policy statement but also indicated that a rate hike in April is unlikely.
In anticipation of an interest rate hike later this year, there are some investors who instinctively want to sell out or lower their positions in bond ETFs and other bond holdings. Meanwhile, there are other other investors that look at the equity market and think that they’re overheated and volatile and they’re seeing safety in bonds.
Rising rates and market volatility and their implications for bond ETF investors was the topic of conversation during Charles Schwab’s Every Third Friday monthly conference call series on ETFs.
Brett Wander, chief investment officer of fixed income for Charles Schwab Investment Management, broke down some common misconceptions that many bond ETF investors are having right now.
The first misconception: Many might think that if the Fed is raising rates that the economy must be in pretty good shape.
“In a typical environment where the Fed is on the verge of raising rates – if you look historically – it means that the economy has really been doing quite well and heating up and there are signs of inflation, the employment picture looks strong, and the Fed is really trying to put on the brakes,” Wander said.
That’s not exactly the case for the current environment, though.
“[T]he economy … is certainly in better shape than it has been over the last couple of years, and things are improving,” Wander said. “The misconception is that the economy is in good shape and I think Janet Yellen underscored some of those points in testimony on Wednesday.”
Wander outlined “three fundamental aspects to the employment picture” that the Fed is concerned about that show the economy still has room to grow.
- Labor force participation. In other words, Wander said, how many people are really working given how many people could be? “As we know, the unemployment rate, which is on the lower side at 5.5%, only looks at the number of people that are looking for a job,” he added. “There are so many people out there that could be looking for a job but have basically given up. And that is captured by the labor force participation rate, which is still really low. That’s a big concern for the Fed.”
- Wage earning levels. Those still haven’t recovered, Wander said. “The unemployment rate is low, but we’re still seeing wage levels that are below and not rising anywhere near the level that the Fed would like to see them at.“
- How long it takes for unemployed people to find a job? “If you look at past post-recession environments, in the current environment people are taking a lot longer to find a job than they had in the past.” Almost two or three times as long, Wander said.
“The labor market really isn’t anywhere near as good as the Fed would like to see them at,” Wander said.
The second misconception: Conventional wisdom says that if the Fed raises rates, longer term bonds will likely underperform.
Wander said he gets this question all the time.
“It’s one of the most common misconceptions out there in the marketplace,” he said. Adding, “what people frequently will say is, ‘Well if rates generically are rising, why would I want to hold a bond fund? Why would I want to invest in a bond ETF?’”
The important insight here, Wander said, is that not all rates are the same.
“The Fed controls short-term rates,” he said. “They have very little influence on longer-term rates. Longer term rates, I’m referring to 10-year securities, 15-year securities, 30-year securities. The yields on those securities, which we’ve seen come down significantly over the course of the last several years, could still stay at very low levels and there’s no reason to assume that they’re going to rise.”
Because longer term rates are driven by growth and inflation, the Fed’s actions should have little impact on longer term rates.