✔ The Fed raised interest rates at the March meeting, the third rate hike in this cycle.
✔ Fed surveys suggest two additional rate hikes in 2017, which was unchanged from December.
✔ Fed rate hikes most directly affect shorter maturity bonds.
✔ Longer dated bonds may not see rates rise to the same extent.
✔ Consider TIPS.
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%.
Viewpoints spoke with Bill Irving, manager of Fidelity Government Income Fund (FGOVX), Fidelity Treasury Inflation Protected Bond Fund (FINPX), Fidelity GNMA Fund (FGMNX), and Fidelity Mortgage Securities Fund (FMSFX). Irving anticipated the Fed move and explained why he thought it would happen, but also why he didn’t expect all bonds to react the same way, and where he sees opportunities now.
What did we learn at the March Fed meeting?
IRVING: As we got closer to the Fed’s March meeting, it had become apparent that a rate hike was very likely.
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.
Do you think the path of rate hikes that the Fed has laid out are likely to materialize?
IRVING: I think the Fed expectation for three rate hikes this year still looks about right. Janet Yellen recently said the pace likely will not be as slow as it was in 2015 and 2016, when the Fed raised rates just once each year. Now that we have had the March rate increase, I think we may see another in June, and then in September or December.
Monetary policy remains very accommodative. The federal funds rate is in a target range of between 75 basis points and 1%, and core inflation is 1.7%. So the real federal funds rate—the federal funds rate minus inflation—is around -1%. Academic research suggests that the "neutral real federal funds rate" is around zero right now. The "neutral" rate, also called "natural" or equilibrium rate, is the federal funds rate that neither stimulates nor restrains economic growth. It's the rate, at least in theory, that would keep the economy moving along at a consistent speed. So the Fed could raise rates four more times just to align the real federal funds rate to the neutral real rate. That seems like a very reasonable goal, considering how close the Fed is to meeting its dual mandate of maximizing employment and stabilizing prices.
Is there any risk in rising growth expectations?
IRVING: I'm keeping a watch on the disconnect between investor sentiment and real economic results. Forward-looking measures aren’t aligned with what’s actually happening in the economy. For example, small-business optimism has shot higher since the election amid expectations for regulatory and tax reform. Yet commercial and industrial bank lending hasn’t picked up, and first-quarter GDP growth is likely to be less than 2%. In other words, the real economy hasn’t caught up yet with the enthusiasm that investors have and the optimism that small-business owners have been expressing.
I also see several things that could temper the optimism and enthusiasm among investors. There’s still a lot of uncertainty about what kind of economic policy we’ll see from the new administration in Washington. For instance, the initial legislative plan to overhaul the Affordable Care Act (ACA) has gotten a chilly reception from some rank-and-file GOP lawmakers. There could be a protracted process to find a compromise that can pass through both houses of Congress. Tax reform and infrastructure spending also could get bogged down. Investor enthusiasm could wane if Congress and the Trump administration can’t deliver what investors have been expecting.
How should investors react as the Fed raises rates?
IRVING: 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.
What areas of the bond market do you find attractive?
IRVING: As a professional bond fund manager, I think it makes sense to have a modest overweight to Treasury inflation-protected securities (TIPS). Although they have risen in value in recent months, TIPS remain modestly priced. The Trump administration has suggested it will adopt a more protectionist trade policy, which could lead to higher inflation as cheaper goods from overseas get hit with tariffs, essentially raising prices for U.S. consumers. An inflation surprise could cause TIPS to outperform.
I’m more cautious on mortgage backed securities (MBS). MBS don’t perform well when interest rates become more volatile, which is a possible outcome of the uncertainty surrounding the administration’s economic policy. What’s more, valuations on MBS aren’t particularly attractive to me right now. It’s also important to note that MBS are relevant to Fed policy. The Fed accumulated MBS as part of its bond buying program, and now owns roughly a quarter of the U.S. mortgage market. As the Fed unwinds its accommodative stance, it may sell its stake in MBS, which could cause those bonds’ prices to underperform Treasuries.
- Bill Irving co-manages Fidelity Government Income Fund (FGOVX), Fidelity Inflation Protected Bond Fund (FINPX), Fidelity GNMA Fund (FGMNX), and Fidelity Mortgage Securities Fund (FMSFX) and Fidelity Strategic Real Return Fund (FSRRX).
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