Liz Ann Sonders Chief Investment Strategist at Schwab went back and researched every interest rate cycle since the mid 1940’s. There’s slow, there’s fast, and then there’s another interesting one to think about which is what is sometimes called the non-cycle or a one-and-done cycle, where the Fed moves once, maybe twice, but then that’s it. It doesn’t turn into the beginning of a cycle.
And that’s the rarer of experiences, although we’ve had four of those since the mid 1940s. But if you look at the slow cycles, on average, the market in the year after the Fed has begun is up 10.8 percent. In the fast cycles, a year after the Fed initiated a fast cycle, the market, on average, is down I think 2.7 or 2.8 percent. And a non-cycle is up there at around 11 percent, along with the slow cycles.
Fed Chair Janet Yellen has indicated the Federal Open Market Committee (FOMC) will be moving ahead on the slow cycle. She said “the process of normalizing interest rates is likely to proceed gradually.” Which makes sense because the FOMC also reduced its forecast for core inflation for 2016 to 1.6% from 1.7%.
An important tool I analyze is the “Dot Plot” chart released by the FOMC’s Summary of Economic Projections. This chart summarizes the FOMC members’ expectations for interest rates. The Dot Plot chart is in coordination with the slow cycle sentiment. The majority consensus is 1.5% in 2016. See below;
What does this mean for your investment portfolios and strategies, not much. What do you mean not much? All of this news and excitement for years about the Fed raising rates, and you say it doesn’t mean that much! Well, Yes 🙂
Let me explain. I have been expecting rates to increase for some time now and our strategies were tweaked in anticipation for this move. More specifically our Bond allocations are designed for interest rate sensitivity and have low durations under 6 years.
What is duration? I am glad you asked! To put it simply we use a bonds duration to calculate how much its price might move when interest rates change. The longer the duration, the higher the risk its price will be affected by a future change in interest rates. See chart below;
Many of my investment strategies hold Exchange Traded Fund (ETF) bond funds. Even though bond prices may fall as rates rise, as holdings mature the proceeds will be re-invested in theory into issues that are paying higher yields and generally mean increased interest over time.
As far as stocks, where are the opportunities in a rising interest rate cycle? Normally U.S. Financials and Technology are reasonably cyclical sectors that may benefit. Please see the charts which shows how financials perform in different interest rate environments;
In our index passively managed ETF investment strategies as of November 30th we have 14% stock exposure to Financials and 12% exposure to Technology. This only represents the percentages of sectors in our stock allocation. For example, if you are in our FPG ETF Growth 80/20 model, 80% of the strategy is invested in stocks. Therefore, of the 80%, 14% is in the Financial sector and 12% is in Technology sector. We are not over weighted in these sectors, however we are comfortable with these levels.
Some of you may be wondering about long-term rates. While long-term rates will eventually start to move. I do not expect to see that happening anytime soon. According to FOMC statement, it will be some time before the they start unwinding their mammoth $4.5 trillion balance sheet.
I have said a lot about a historic fed decision that I also said in the grand scheme of things does not mean that much. That is true, however, let me clarify. I absolutely believe what happened on Wednesday is important. The fact that the FOMC raised rates is an expression of support of the U.S. Economy. In my opinion if the FOMC did not decide to raise rates that would have been a terrible sign for our economy.
Joe Carbone, Jr.
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About the Author: Joseph Carbone, Jr.