It seems like de-ja-vu. In September we talked about the Fed possibly raising rates… they didn’t. The conversation happened again in October… nothing. Here we are in December having the same conversation.
The December jobs report, which looks at job creation in November and adjusts for prior months, was strong. It showed that we added 211,000 jobs in November and we adjusted prior months (which were deemed poor jobs months) very handsomely.
Inflation is muted, but we have started to positive trends with wage growth (trending higher) and unemployment (trending lower). Combine this with a Fed that is anxious to at least get off of 0% interest rates, you get a December full of talk surrounding whether the Fed will raise rates.
The consensus is that the Fed will finally get off of 0% interest rates and raise short term interest rates 0.25% on December 16th. But it seems that the strategy for the Fed will be one of raise and pause. They aren’t committed to raising rates at every meeting as we have seen during past rate increase periods. Rather, this Fed will likely raise in December and then pause for a couple of months. Actually, we are only anticipating 3-4 rate increases in 2016.
Our economy is not out of the woods yet and this is why the Fed is looking to take a “raise and pause” approach. As mentioned earlier, inflation is still muted, which means drastic monetary tightening measures are unnecessary. We still need to see wage growth accelerate much faster than we have recently seen. The trend has been good, but for a consistent rate increase policy, wage growth needs to be accelerating much faster.
So, what does this all mean to you?
Despite a small rate hike this month, the Fed is still, from a historical measure, very accommodative. This means that borrowing money is still easy. In all honesty, is paying 0.25% that much greater than 0%? We are talking about $250 on $100,000 borrowed. That’s still very accommodative for the Fed and positive for markets. Furthermore, does the Fed raising interest rates by 0.25% prevent Apple from releasing the next iPhone or Apple TV? Or will Tesla cease to innovate automobile technology because the Fed decided to move rates by a quarter of a point? We certainly don’t think so.
Also, investors are forward looking. What this means is that they usually build assumptions into what they are willing to pay for investments. Meaning that value movements in investments tend to occur before news on particular events hit the wires.
We can already see this within the Treasury bond market. The 10-year treasury bond is what many people tend to use as a gauge for the bond markets. In October the 10-year treasury yield was below 2%. Today, the 10-year treasury yield sits near 2.30%. Remember that when yields rise, prices fall. What this shows is that investors have already sold treasuries prior to the Fed meeting.
Looking at shorter term treasury bonds is more telling with regards to the Fed, because the Fed really controls short term rates. So, looking at the two year treasury yield, it has moved from 0.55% on October 14th 2015 to 0.95% as of Monday December 7th. That’s a jump in yield of 73%. But the Fed does not control the intermediate or long term interest rates. So, we wouldn’t be surprised to see a flattening of the yield curve. Think of the yield curve as a graph that charts different interest rates across different time periods. So the further out on graph you go (i.e. longer time horizons) should yield higher interest rates. This is to compensate the investor for committing their dollars for a longer period of time. And conversely, on the short-end, you would expect to see lower interest rates since the investors dollars are not tied up for very long. In the case of a flattening yield curve, you would see short term rates rise quicker, on a relative basis, than long term rates. If this happens, then you’ll likely see intermediate and long term bonds hold their value.
Investors are already anticipating a rise in rates in December. That is why we don’t anticipate much fallout once the Fed makes the actual announcement. This is one of the reasons the Fed has tried to be so transparent all these years.
And with this information, what should you do?
Very simply… stay diversified. An announcement by the Fed in December to raise rates, shouldn’t drastically alter your investment allocation or your goals and objectives.
We want to continue to maintain the appropriate exposure to both stocks and bonds. Both of these types of investments serve a purpose… a great purpose. Stocks help us to see some appreciation over the long term, while also proving, historically, to be a good hedge against inflation. And bonds will continue to be a good option when we experience stock market volatility.
Long term investment success will be determined based on staying true to your longer term investment philosophy. Keeping your core (or majority) of investments in core investments like the broad stock and bond market. And then adjusting your allocation accordingly as you near retirement or as your goals and objectives change.
For Wela clients: We are always here to chat with you. News headlines will be abundant over these next few weeks. Trust that we are aware of what is going on and if needed will make necessary adjustments for you and your portfolio.