For the first time in nine years, the Fed raised interest rates. In the middle of the month, the Federal Open Market Committee (FOMC) initiated a tightening cycle for the first time in more than 11 years by raising the target for the federal funds rate by 0.25%. The widely expected decision marks the end of a long, seven year period of zero interest rates to combat the effects of the financial crisis in 2008. This is a big event (well, maybe notStar Warsbig) because of how long zero rates have been in place.
The Fed had been talking up interest rates all year without doing anything. The initial market reaction was quite favorable, with one major uncertainty out of the way. So what is next? The FOMC put the word "gradual" in its statement twice, and Chair Yellen uttered the word a total of 15 times. Once market participants carefully read the FOMC statement, though, the markets sold off. The statement suggested that the Fed would be raising rates once a quarter over the next year. Will it? Perhaps more uncertainty…
Our view is that the economy has been slowing, so the Fed’s timing on raising rates is unusual. If the economy continues to slow, long-term rates will remain subdued. Low interest rates overseas should also keep U.S. bond yields from moving higher. Foreign investors continue to find U.S. Treasuries attractive compared to bonds where yields are being held down by bond purchases from European and Japanese central banks. Further rate rises may just flatten the yield curve. This environment favors rate sensitive areas of the equity market.
Real estate construction and real estate investment trusts (REITs) should benefit from low interest rates. We have not seen the overbuilding that has occurred in past real estate booms, suggesting a reasonable supply-demand balance. And if 10 year yields remain at current levels, REIT yields will be relatively more attractive. The utilities sector exhibits a high degree of sensitivity and is used by some investors as a bond substitute. In fact, longer dated bonds may be a contrarian bet since the consensus expects rates to rise. If we are correct, and the yield curve flattens, the benefit to traditional banks will be limited from any rise in short-term interest rates.
The Fed’s interest rate move implies confidence that the economy is strong enough to stand on its own. Steady economic growth would, indeed, support modest gains in equity prices. Further rate increases, though, may jeopardize growth. As the markets try to anticipate the Fed’s next move, we would not be surprised to see volatility as the risk on, risk off trade continues into 2016.
- The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Investing in real estate/REITs involves special risks and may not be suitable for all investors.
- Because of its narrow focus, specialty sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise.
- Data provided by LPL Financial.
- All investing involves risk including loss of principal.