For months, the markets have been focused on Federal Reserve policy—with bond interest rates and stock markets reacting to expectations that the Fed would slow down bond purchases and reduce support for the economy. After the September 19 FOMC meeting, the Fed announced that the wait will continue. Due to mixed economic data it won’t start reducing its asset purchases—yet.
Still, the prospect of tapering looms on the horizon. So, Viewpoints asked four Fidelity experts to weigh in on what Fed policy and rising interest rates may mean for the economy and investors.
Lisa Emsbo-Mattingly: Will tapering derail the economy?
About the expert
Think of the U.S. economy as a patient who suffered a massive heart attack in 2008. He’s been on life support for the last several years, and moving away from quantitative easing—tapering—is his first tentative step away from the bed. The Fed is trying to see whether the patient can walk away from the bed under his own power.
The big concern is, could tapering derail the current economic expansion, and, more specifically, what will it do to the housing market. I think tapering could slow the housing recovery, but at the same time extend it and make it less volatile. That could provide a nice long-term tailwind to the U.S. economy and help to end the boom-and-bust cycle we have seen in the past.
In recent years we have seen negative real returns for long-term bonds and a flattening of the yield curve, indicating investors had serious concerns about growth and deflation. But more recently, interest rates have shown signs of a more normal economy. The inflation-adjusted rate on the long end of the Treasury curve has turned positive, and at the same time, the yield curve has become steep. Those two factors tell you that the markets and the economy are starting to anticipate growth and are constructive for continued expansion.
I expect bumps in the road that drive volatility. But when tapering does happen, I don’t expect it to derail the recovery. I think the economy’s slow expansion could continue.
Julian Potenza: Prepare for potential volatility
About the expert
The Fed clearly wants to reduce bond buying, but not before the economy appears able to handle lower levels of monetary accommodation. As the markets and economy react to these shifting intentions we could see uneven progress and volatility.
The reduction of bond buying is dependent on strong economic data. To wrap up the program by the middle of 2014, which appeared to be the Fed’s intention as of June, the Fed would need to see firm signs of robust, above-trend growth—while thus far we have had a sluggish and inconsistent expansion.
Even after the Fed does decide to taper, which I think could happen fairly soon, I believe it won’t begin raising short-term interest rates for quite some time. The Fed has committed to keeping interest rates very low at least until the unemployment rate hits 6.5%, which it has said it expects in early 2015. But even that target might change—unemployment has fallen faster than expected, but largely because people have dropped out of the labor force. If that phenomenon persists, the Fed might decide to lower its rate-hike threshold, perhaps to an unemployment rate of 6%, particularly if inflation stays low. So, I expect short-term rates to remain low for the foreseeable future, and this should be a supportive factor for the fixed-income markets overall.
Also, the yield curve is very steep by historical standards. This suggests that the long end of the yield curve has reacted to the increased likelihood of an eventual Fed taper, while the front end has remained anchored by the Fed’s plans to keep rates low well after the asset purchases end. Because tapering is priced in, I wouldn’t expect a large move in the yield curve when that policy change takes place. If the economy does improve as the Fed expects, the curve will most likely flatten. If the economy disappoints, long-term rates could fall meaningfully again—also leaving the curve flatter.
The bottom line: Bond investors may need to prepare for some volatility, and the potential for rising rates should the economy improve. But economic improvement is by no means guaranteed, and there are several factors that could support the market and limit the impact of a tapering announcement. This underscores our belief that despite the rate environment, bonds still can play an important role in a portfolio.
Robert von Rekowsky: The “vicious” feedback cycle with emerging markets
About the expert
There is definitely a feedback loop between the U.S.—and in fact developed markets in general—and emerging markets (EM). Sometimes it’s a virtuous cycle, and sometimes it’s a more vicious one.
The U.S. economy’s recovery helps emerging markets by creating more U.S. demand. But the expectation for rising interest rates also weighs on certain emerging countries. Some countries have chosen to raise rates themselves to prop up their currencies, and that can slow growth. There’s the risk that some emerging markets might overshoot and raise rates too much, crimping demand at home. I still expect EM countries to grow well above developed markets in aggregate, but I think there will be a very wide disparity between countries.
The biggest single driver for the emerging-market debt market is U.S. interest rates. One broker recently estimated that outflows from emerging-market equity and debt funds totaled $60 billion over the past three months, which coincides with the rise in U.S. long-term rates. However, I think the bulk of outflows related to the taper announcement are probably behind us now. The emerging-markets-debt team does expect another round of EM-debt outflows when U.S. short-term rates eventually rise, but probably of a lesser magnitude than has been experienced so far. On the whole, the EM-debt team remains cautious regarding near-term volatility being driven by the policy backdrop and state of the U.S. economy.
On the equity side, the announcement of Fed tapering plans back in May has had the greatest negative impact on emerging-market stocks in countries with significant current account deficits, including South Africa, Turkey, India, and Indonesia, to name a few. I expect that negative current-account countries will continue to have the most difficulty over the coming six months, as the Fed begins to taper. Bear in mind, however, that emerging-market stocks are approaching low relative valuations, which could make them more attractive to investors again.
Chris Lee: Winners and losers in financial services
About the expert
Financial service companies in general are very sensitive to the rate environment. On the whole, rising rates are positive for financial service companies. But the implications vary among different types of financial services companies.
Companies that invest in short-duration assets stand to benefit from a rising-rate environment. These include online brokers and banks that hold short-duration type assets, either through securities or the structures of their loans. These areas have been hit hard over the past five years, so any recovery in the short end of the curve would really help them from, an earnings standpoint.
Rising rates are a net positive for banks, but there is a bit of a timing mismatch. Higher rates can have a negative impact on banks’ book values in the short term. But higher rates also allow banks to invest their deposits at higher yields, which is positive for their net interest margin. Other positive developments in the economy, like improving credit and higher loan growth, should help support banks in the meantime.
Other areas may not benefit as much or at all from higher rates. They include investment banks and other businesses related to capital markets activity, because higher rates tend to be headwinds for debt issuance and the like. Likewise, banks that issue a lot of mortgages are exposed as rates go higher. Another obvious area is REITs—real estate investment trusts—which tend to buy hard assets and finance them with debt. As rates go higher, the value of their assets may come down while their capital rates and cost of funding rise. REIT valuations are very high, so I believe they look somewhat vulnerable.