The Fed Holds Off, but What’s Next?
Last week’s Fed summit didn’t provide much clarity about where rates are headed. We offer some ways to take advantage of the uncertainty.
By Amey Stone
But investors shouldn’t be too complacent about chances for future rate hikes. Financial markets are a lot stronger than they were earlier this year. The job market and consumer spending remain healthy. And—here’s the key—first quarter economic weakness could well be temporary.
If those are strong, a June hike could start to move back on the table. Plenty of strategists think the Fed could make good on its plan to hike rates twice this year. “To get to two, they have to have one in June,” says Tom Kersting, head of fixed-income research at Edward Jones.
Investors hoping last week’s Federal Reserve meeting would provide some clarity about where interest rates are heading got only the most subtle of clues.
As expected, the Fed didn’t hike rates. Instead, it achieved the rare (and intended) feat of giving no indication of whether it would anytime soon. Many strategists took that in itself as a sign there would be no rate hike in June, since the Fed would have to do more to prepare investors if that was indeed the plan.
The economic releases that followed the Fed’s Wednesday policy statement cemented that dovish outlook for rates. Thursday’s initial reading for first-quarter gross domestic product showed growth of just 0.5%, down from 1.4% in the fourth quarter of last year. On Friday, the Fed’s favorite inflation measure, core personal-consumption expenditures, was reported up 1.6% in March, still well below the Fed’s 2% target.
That’s been the pattern of recent years. Sure, businesses aren’t spending, corporate earnings have been disappointing, and consumer sentiment has been tested by negative campaign rhetoric. But Jim Caron, a fixed-income portfolio manager at Morgan Stanley Investment Management, believes the effects of the first quarter’s financial mayhem are still being felt and will fade.
That would explain why conditions that would normally spark a rally in government bonds—weak economic data and the Fed on hold—have failed to do so. Treasury yields (which move inversely to prices) are higher than they were for most of the month. The yield on the 10-year Treasury hit a five-week high on Tuesday of 1.94% before slipping back and ending the week at 1.83%—still not much of a rally. “The market is looking through this a little,” says Caron. “It expected these economic numbers to be weak.”
The key to Caron’s rosier outlook is that central banks in Europe and Japan are also on hold and avoiding more currency devaluations and negative interest-rate moves, giving financial conditions a chance to stabilize. That’s good for economic growth and riskier assets, such as high-yield and emerging-market bonds, which have rebounded sharply.
HIGHER PRICES FOR OIL, gold, and other metals may be signaling an increase in demand as financial conditions calm in China and emerging markets. The strong U.S. dollar, which contributed to turmoil in the global financial system, has weakened, points out Rick Rieder, chief investment officer of global fixed income at BlackRock. That alleviates a “stress point” for global economies.
If central banks “stay out of the way”—a pretty big if—investors should embrace risk and exercise caution with Treasuries, says Caron. He likes high-yield and emerging-market bonds and thinks Treasury yields could “leak higher.” He doesn’t expect a Fed rate hike until December.
Next week brings more Fedspeak, as well as April nonfarm payrolls and a key manufacturing report.
Given the uncertainty, loading up on junk and emerging-market bonds after the recent run-up is risky, says Putri Pascualy, credit strategist at Paamco. She likes corporate debt, but thinks investors should look for pockets of value, such as bonds of midsize companies and syndicated loans, which have lagged in the rebound. Says Pascualy, “I think being cautiously optimistic is the prudent approach.”