The Fed's Silver Lining for Retirement Portfolios

On Wednesday, the U.S. Federal Reserve raised its benchmark interest rate by 75 basis points, marking the fourth consecutive hike of that magnitude undertaken this year.

Federal Reserve Chair Jerome Powell, offering remarks at the end of the closely watched Federal Open Market Committee meeting, said incoming data suggests the ultimate level of interest rates will likely be higher than previously expected.

While Powell’s speech has been perceived by market analysts as “remaining hawkish,” the Fed Chair also emphasized that it could be appropriate to slow the pace of increases “as soon as the next meeting or the one after that.”

“No decision has been made,” Powell said, and he stressed that the U.S. economy still has some ways to go before rates are tight enough. Powell added that it is “very premature” to be thinking about pausing.

As noted by FOMC watchers in the wake of Powell’s remarks, the Fed’s decision was unanimous, and it lifted the target for the benchmark federal funds rate to a range of 3.75% to 4%. This is the highest level since 2008.

For retirement-focused investors, one of the highlights from Powell’s speech came when he said he feels the pace of hiking is not as important as “how high we will need to get on rates.” Ultimately, according to Powell, the level of the terminal rate may be higher than previously expected.

Market experts say this message has both positive and negative implications for investors. While they may see further losses on the equity side, and while the market value of a given bond portfolio could fall further, higher rates present an opportunity to lock in attractive yields moving forward.

Implications for the Markets

In written comments shared with ThinkAdvisor following the FOMC meeting, Jason England, global bonds portfolio manager at Janus Henderson Investors, says he is not surprised to see a fourth straight 75 basis-point hike. He points out that key data released since the last FOMC meeting all but guaranteed another unusually large rate increase.

According to England, once the FOMC statement was released, the focus of investment analysts shifted quickly away from the large current hike to the new language in the statement around the pace of future rate hikes. England says there is particular interest brewing with respect to how the Fed will take into account the cumulative tightening that has already been done, and the simple fact that monetary policy works on a lag.

“Although Chair Powell did hint about slowing the pace of hikes at one of the next two meetings, he did say that it is premature to discuss pausing and it is not a conversation the committee is having now,” England noted.

In considering Powell’s remarks, England feels a slowing of the pace of rate hikes does not equal a pause, and the final destination of rates may be higher than currently anticipated. He says the Fed very well may stay higher for longer, until they see clear and convincing evidence that inflation is returning to the 2% target.

Implications for Retirement Investors

Taking to Twitter in the wake of the Fed meeting, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial research, pointed out that bond market volatility is now approaching the March 2020 highs seen during the height of the first wave of the COVID-19 pandemic in the United States.

As Jones noted, the equity and bond markets now appear to be pricing in smaller rate hikes, likely 50 basis points in December, but a higher peak rate. Writing in response to an inquiry from ThinkAdvisor, she offered some more specific thoughts about what retirement investors should take away from this week’s Federal Reserve news.

“For retirees, the rise in yields is a great opportunity to generate income for portfolios,” Jones says. “This is the first time in years that yields have been this high, and the rate outlook provides income investors a chance to lock in those yields for the long term.”

As Jones points out, real yields are high as well — the highest since 2009 — as measured relative to inflation expectations.

“You can build a portfolio of high-quality bonds (Treasurys, investment grade corporates and municipal bonds) generating yields of 6% with duration in the 5- to 7-year range,” Jones notes. “That means investors who have been having to rely on equities or other riskier assets don’t have to reach for yield and take that much credit risk.”

Given the potentially recessionary environment, Jones is feeling “much more cautious” on credit risk, especially within higher yielding bonds. These bonds tend to be highly correlated with equities, she explains, and the risk of default rises during an economic downturn.

“Some investors will have unrealized losses in bonds or bond funds,” Jones adds. “That may mean harvesting a tax loss and reinvesting or just holding to maturity. It depends on the individual situation.”

Overall, Jones and her colleagues at Schwab think the risk of recession is high and rising, and that fact will likely weigh on risk assets.

“However, the upside is that we look for the Fed to ease rates in late 2023, which should mean that bonds generate potential capital gains as well as current income,” Jones says.

Don’t Invest Too Much

In a new blog post published on his firm’s website, Duane McAllister, a managing director and senior portfolio manager at Baird Asset Management, echoes many of Jones’ sentiments about emerging opportunities. Like Jones, he warns that the appeal of short-term rates could cause some people to invest “too much, too short and to stay too long at this short maturity free-lunch counter.”

According to McAllister, the perceived free lunch of receiving more reward in the form of higher yields for less interest rate risk by staying short was as tempting in each of the previous economic cycles as it is now.

“And, while it appears as both the rational and optimal choice today, it was, in fact, the suboptimal selection from both a total return perspective and on a yield basis,” McAllister warns.

Like Jones, McAllister says investors should be seriously considering the opportunity to lock in a relatively high-income stream for much longer, rather than focusing only on the short end of the yield curve.

“Cash flow is king,” he says, “and the longer it flows, the better.”