After many years in which interest rates were very close to zero, global economic conditions have changed and rates have begun to rise again, albeit quite gradually and orderly. With a Federal Reserve anticipating further increases in the short term, investors must now prepare for financial conditions not seen in a while.
To begin with, why is it that the rise in rates matters so much? Credit is the fuel that drives the global economy, and therefore it is what feeds the stock market, the labor market and the financial world in general. If interest rates and therefore the cost of credit rise, both global economic growth and the value of financial assets inevitably suffer.
What levels has the benchmark rate been at recently? At low levels, very low. In response to the financial crisis of 2008-2009, the Fed reduced the benchmark rate to almost zero to stimulate credit and thus economic growth. As the economy has strengthened, the Fed has begun to ease the monetary stimulus and raise the benchmark rate, again. Despite seven increases of 0.25% each since December 2015, at its current level of 2%, the benchmark rate remains below its historical averages.
And how have market rates behaved? They have also risen, but to a lesser extent than the benchmark rate. For example, in September 2017, the 10-year U.S. Treasury rate was 2% and now it's close to 3%. The rise has been a consequence not only of the Fed's upward adjustment in its benchmark rate, but also of the strengthening of the economy, the benefits of the tax reform passed in late 2017 and the increase in the US fiscal deficit.
How far could the rates rise? In a context in which we expect global growth to remain strong and inflation to remain healthy, we are forecasting the Fed to raise the benchmark rate twice this year and three or four times in 2019 until reaching a terminal rate between 3.25% and 3.50%. We also anticipate that the 10-Year Treasury rate will be 3.10% at the end of 2018 and the 2-year rate will be 2.80%.
How does the rate hike impact the bond market? When interest rates rise, the price of bonds usually falls, but not to the same extent. Longer-term bonds, which are those with longer maturities, tend to suffer more than shorter-term bonds. An effective way to protect against rate hikes is to invest in floating rate notes, which offer higher yields as interest rates rise.
If you wanted to invest in bonds, how should you do it? The best way to do this is through a fairly well-diversified investment strategy that seeks to benefit from higher rates and a flatter yield curve by combining short-term instruments with floating rates with longer-term instruments of high credit quality.
But why invest in bonds at all? The main reason for this is diversification. If the economy were to weaken suddenly or any unexpected factor were to put negative pressure on the stock market, the price of bonds in the diversified portfolio could rise and thus soften the blow. During the financial crisis of the past decade, diversified portfolios suffered the least and recovered the fastest.
What events related to interest rates are worth monitoring in the short term? The monetary policy decisions of the Federal Reserve. A healthy US economy and relatively buoyant global growth should continue to create optimal conditions for the Fed to continue to raise rates and thus strengthen its arsenal of monetary instruments to cope with the next recession, whenever and wherever it may occur. While we do not expect a sudden rise in interest rates, we do expect a gradual rise. The rate hike will undoubtedly impact the price investors will be willing to pay for their investments in stocks, bonds and floating rate notes. In this context, monitoring the Fed's actions and signals is of vital importance.
To learn more of our perspective on interest rates and the macroeconomic landscape, we invite you to contact your J.P. Morgan advisor.
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