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3 Reasons Not to Worry About the Fed’s First Rate Hike

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Click to enlargeThe first interest rate hike by the Federal Reserve in more than nine years will not be the big event that the market has been anticipating, according to a panel of fixed income strategists and portfolio managers who participated in a recent Envestnet Institute webinar.

Their reasons have nothing to do with the latest market rout, which, has more than erased any gains in the stock market this year, and could potentially delay a Fed rate hike. They relate instead to the context in which the Fed will be raising rates and the history of market performance when the Fed has tightened policy before.

The panelists were William Rodriguez, fixed income strategist at BlackRock; Mark Mowrey, senior vice president and portfolio manager at AFAM Capital and Innealta Capital; Scott Eldridge, director of fixed income product strategy at Invesco PowerShares Capital Management; and Frank Pape, director of consulting services at Russell Investments’ private client services business.

Here are their reasons why investors and advisors shouldn’t be overly concerned about an increase in the Fed funds rate, the short-term interest rate that the Fed directly controls and that banks use to lend funds to one another overnight.

1. Rates Will Still Remain Low & Negative for a While

The Fed will raise rates only 0.25% this year, finally moving off zero, or more specifically off the 0-0.25% range it has maintained since December 2008. Even after the first rate hike, “the Fed will be fairly accommodative for a number of years,” said Rodriquez of BlackRock. “The pace will be benign enough to not be ultimately market-disruptive.”

“The Fed is not off to the next tightening cycle,” said Scott Eldridge, director of fixed income product strategy at Invesco PowerShares Capital Management, noting that the Fed remains concerned about the weakness of the economic recovery and the persistent lack of inflation indications. “We don’t expect to see like we’ve seen in the past, that ratchet, ratchet ratchet type tightening policy at every meeting, but much more of a move and pause, move and pause with maybe 2-3 moves over the next 6 months.”

“Even if the Fed were to raise interest rates 25 basis points this September or December – we’re not ruling out October – once you subtract the weak inflation rate you’re still negative with regard to real Fed funds,” said Rodriquez. “It isn’t until we approach real Fed funds in excess of 2% to 3% where you start to see some real tightening in the marketplace.”

(The Fed has an inflation target of 2%. Its favorite inflation measure is personal consumption expenditures minus costs for food and energy, known as core PCE, which is running at 1.29%. So with a 0.25% Fed funds rate, the real rate is -1.24%.)

2. Higher Borrowing Costs Won’t Hurt, Could Even Help

Ultimately a Fed rate hike will lead to higher borrowing costs, but not right away — and maybe not at all for long-term loans. Mark Morey, senior VP and portfolio manager at AFAM Capital, expects short-term rates will rise over the next 12 to 18 months following Fed rate hikes but the long end of the yield curve won’t, resulting a flattening of the yield curve. If he’s right, then the rates on long-term loans like 30-year fixed mortgages won’t rise. On the other hand, Rodriguez said, the higher cost of Fed funds “will ultimately translate into a higher cost of capital [for corporations]” and encourage CEOs and CFOs to invest in capital projects sooner than later “for fear of rising interest rates it the future.” He said it’s already happening given the $124 billion in corporate debt issued in July.

3. Markets Have Performed Well After Fed Hikes

Despite conventional wisdom, Frank Pape, director of consulting services at Russell Investments’ private client services business, said markets have performed well after the Fed begins to raise rates. Looking at past performance of major stock, bond and real estate investment trust indexes during the seven Fed tightening cycles since 1980, he found that returns were positive in the one year and five years following, ranging as low as 3.6% for the Barclays Bond Aggregate to as high as 13% for non-U.S. stocks in the first year.

Despite these positive expectations about the impact – or non-impact – of Fed rate hikes, the panelists cautioned that investors should still be prepared for more market volatility once the Fed makes its move, which could happen as soon as next month, October or December.

“Keep enough liquidity” so you don’t have to sell into a panic, said Eldrige. “Focus on risk-adjusted returns, not just returns,” said Rodriguez.

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