Jason Method: The new Federal Reserve chairman has said the economy is strengthening. Interest rates have been rising, and most analysts believe the Fed will hike rates another two or three times this year. What’s an investor or advisor to do?
Hello, and welcome to Vanguard’s Investment Commentary podcast series. I’m Jason Method. In this month’s episode, which we’re taping on March 26, 2018, we’re going to discuss why interest rates are rising and what should investors do about it.
Joining us today is Josh Hirt, an investment analyst in Vanguard Investment Strategy Group. Hello, Josh, and thanks for joining us.
Josh Hirt: Thanks, Jason. It’s good to be here.
Jason Method: Interest rates have really been rising since 2016, but they are up more sharply since September. Why is this happening?
Josh Hirt: The short answer is better economic fundamentals, better economic growth. Perhaps as a backdrop, it’s helpful just to think about where we’ve come from. So coming off of the financial crisis—a period of historically low interest rates, low interest rate volatility—and really, what we’ve seen now, since beginning in 2015 more or less, is that the economy has strengthened. The growth in the economy has been more broad-based. The Fed has responded to that growth by raising interest rates. And the level of interest rates that are in the economy can be supported now fundamentally. So it is for positive reasons that we’re experiencing the interest rate rise.
Jason Method: A strong economy is always a good thing, except that rising interest rates also mean higher credit card rates, higher loan rates, and it also means different things in the market as well. The new Federal Reserve chairman, Jerome Powell, is beginning to put his stamp on the central bank. Analysts and market commentators believe there’ll be at least another two to three rate hikes this year. In Vanguard’s view, how high and how fast will the interest rates rise?
Josh Hirt: We have seen market consensus sort of tick up as economic growth has begun to occur at a more rapid pace. So our view has been three interest rate hikes for 2018—so an additional two hikes this year—and three rate hikes for 2019.
Generally, we’ve been expecting that the new Fed under Chairman Powell will follow a very similar playbook to that the Janet Yellen Fed had taken, which was a rather orderly and very data-dependent approach to normalizing interest rates. So our expectations have remained relatively sound that interest rates will continue to increase at a moderate pace that is consistent with economic fundamentals in the economy.
Jason Method: Now, we know economic fundamentals are something the Fed keeps its eye on, but it also worries a little bit about inflation, right? They’re charged with keeping inflation under control and maintaining that price stability. Commentators often point to various factors, such as the unemployment rate or hourly wages, that could show inflation is coming. Are there any particular reports or numbers that you look at to see whether that is indeed the case?
Josh Hirt: Yes, inflation has been really a key issue for us for a good period of time now. It’s something that we wrote about in our 2018 economic outlook. A lot of these metrics are important, so keeping an eye on headline inflation numbers such as consumer price index, personal consumption expenditures, also looking at business surveys and the prices that businesses pay for goods and services, because that’ll ultimately show [its] face in the economy in some way.
Certainly, the unemployment rate and the level of unemployment is something that has traditionally had a very good relationship with rising wages, as we’ve got such a tight, firm labor market at this period of time that tends to have put pressure on wage metrics, which ultimately shows through into inflation. So these are all really important aspects to keep an eye on.
When we look holistically at the data, our analysis would suggest that there are some modest inflation pressures that have been creeping up in the economy, but it’s not something that we’re going to see, in our view, a significant rise or a significant spike. So we’re expecting it to move toward 2 percent by the end of 2018, but the path might be a little bit bumpy. Some of this we may have already experienced in the beginning of this year with the wage numbers that came out in the January job report.1For us, we see a firming trend in inflation, and it’s not something that we would suggest an investor should be worried about.
Jason Method: I want to talk about this firming trend and what it means really to bond funds and ETFs, because interest rates have a particular effect on those investments. What does a rising-rate environment and perhaps a little higher inflation mean to bond investors?
Josh Hirt: Right. Certainly for a fixed income investor, interest rates is really the most important component of the return that they experience. So keeping an eye on that is a key element.
I would start by saying that I think it’s really important to just differentiate the fact that different investors are going to experience things differently through interest rate increases. We tend to talk about interest rates in broad terms, but in reality, it means very different things. So today we’re discussing more specifically the fed funds rate and the Fed’s control over interest rates. But that has different effects from the short end of the yield curve, short-term rates, and long-term interest rates.
As you mentioned, this affects credit card rates and mortgage loan rates differently as well. So I would just say that there’s nuance to this and that not everyone is going to experience the same elements as interest rates do rise. Sort of bringing it back more to ETFs, bond funds, etc., I think an important point of that is, where are they investing from a duration standpoint? Is that matched with their appropriate goals?
Jason Method: You’ve used a pretty big term there, duration. Can you help us understand what that means?
Josh Hirt: Sure, well, I mean, you can think about duration as, really, the wait of time to get your money back from that bond. You could use it as a gauge for how appropriate your horizon is with the bond. If you have a goal that’s six years out, having a duration that’s closely matched to that would be something that we would say is a prudent approach rather than investing in a security that has a long duration, you know, maybe 10 or 15 years, for a goal that you’re looking to purchase a house in a year. There’s going to be significantly more interest rate volatility with longer duration. It’s a measure of interest rate sensitivity.
So I think that’s a really important component of this, because we are expecting to see increases in the short-term interest rates over this period of the hiking cycle. But our view [is] that the long end of the yield curve is actually relatively tamped down by structural factors; and so I think it’s an important point to mention that different investors should have different expectations.
Jason Method: Now, you mentioned our annual economic and market outlook, and in there, I know that we had mentioned that bond returns are expected to be very low over the next ten years or so. Some investors may see that they’re not getting as much from those bond portfolios as they used to, and they might even be tempted to reduce or eliminate their bond holdings. Is that a wise idea?
Josh Hirt: It’s a really good question. Bonds are a very important part, especially of a balanced portfolio.
Just due to the fact that the diversification benefit that bonds have in diversifying equity risk is really a key reason that we think it’s important. Especially in periods of stress in the equity markets, fixed income tends to act as a ballast and to be a diversifying element in the portfolio that allows investors to stay invested, to not abandon their plans because they have a smoother ride, so to speak, due to that diversification benefit as the equity markets are having volatility or stress. The fixed income markets tend to counterbalance that.
Jason Method: Some investors think that there are some types of bonds or even bondlike investments that might be a counterbalance but also give a better return; for example, high-yield bonds or real estate investment trusts, otherwise known as REITs. What do you think about that?
Josh Hirt: I’d go back to how we view the role of bonds and mentioning that we view the real role of bonds in a portfolio as a diversifier to equity risk, especially when there are periods of time in the market that are stressful from the equity market standpoint.
You want bonds to act in that role when you need them most. What we see historically is that one of the things that allows bonds to act in that framework is high-quality bonds. So investment-grade2bonds tend to be a very good diversifier of equity market risk.
When you start looking at securities such as high-yield bonds or REITs, for instance, they don’t have those same diversifying properties that you would see from high-quality fixed income. And through our analysis, when you look at this historically, periods of stress don’t bring the same level of diversification to the portfolio, which we view as the ultimate role for bonds. And so you want your bonds to act as bonds when you have them; so something to keep in mind with those different approaches.
Jason Method: And what you mean by that, by diversification, just to be clear, is that when the stock market tanks and goes down, that the bonds either won’t go down or maybe won’t go down nearly as much.
Josh Hirt: Yes, and oftentimes you tend to see that fixed income securities rise in value during periods when the equity market is declining for that exact reason. So you laid it out perfectly.
Jason Method: Now, in this whole conversation, we’ve talked about bonds mainly in the context of the U.S., like Treasuries and corporates. How important are international bonds?
Josh Hirt: We view them as a very important part of investors’ portfolio[s]. It’s one of the largest segments of the market—the global investable portfolio, so to speak. And so we definitely think that investors should have exposure to that. It provides just a swath of diversification in a number of different areas that we think benefit investors, just from an individual name and credit standpoint, but also from an interest rate diversification.
You know, we’re talking today about interest rates, rising interest rates. Why is the Fed raising interest rates currently? If you think about other regions of the world, they’re doing things that are different from what the Fed is currently, and their interest rates are moving differently from the Fed. And so by bringing in the international exposure to bonds, you do have that interest rate diversification that also benefits investors, so something that’s topical at this point in time.
Jason Method: Let’s get back to the current situation with rising interest rates. They may go higher this year, next year. People like to think about, well, what do I need to do now? Is there anything about now that they should do differently?
Josh Hirt: I would say that first and foremost, to just keep in mind where we’ve been, to put some context around this current interest rate cycle. And, you know, we’ve really come from, since the financial crisis, a period of very low volatility. We’ve gotten used to having very low interest rates, and we’re now starting to move away from that. So all of the things that were put in place to stabilize the economy, to enable it to get back to a growth trajectory, they’re now starting to be unwound.
For us, that suggests that there could be some times when the volatility spikes, and that’s actually very normal in the markets.
Jason Method: Do you mean stock volatility?
Josh Hirt: Equity market volatility as well as interest rate volatility. You know, we’ve seen fixed income rates rise, have a pretty decent rise in yields over the last three and six months, even beyond that, at all parts along the yield curve. So really both components bringing financial risk to the markets in a bit more elevated context. But it’s important to understand that’s actually very normal in the course of markets historically.
You know, in terms of doing things now, I would say that, hopefully, most investors have a well-thought-out plan that they put in place. And if this volatility is something that’s maybe causing them to question that, this could serve as a good period of time as sort of a circuit breaker check-in with your advisor. Check yourself, if it’s something that you do yourself, and make sure that you’re comfortable with your plan in terms of how you’ve allocated stocks and bonds; if we’re looking at fixed income specifically, how you’ve allocated, as we talked about duration, and are you appropriately matched with your time horizon? And so I think those would be good things to use this period of time for.
Jason Method: Thanks for helping us with that, Josh. Let me see if I can summarize that for our listeners. Interest rates are rising. Bond investments continue to be an important part of an investor’s portfolio. Investors should always stick with their financial plan, if they have a good plan, but if they’re worried, it might be a good time to review that plan or maybe talk to an advisor.
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1 The employment report issued February 2, 2018, by the U.S. Bureau of Labor Statistics covered nonfarm payroll for the prior month, January.
2 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
All investments are subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
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