Interest Rates Not Likely Going Up Anytime Soon
The experts are at it again, conjuring up fears of imminent interest rate increases and a catastrophic downturn for bonds. Virtually every financial publication, television program and webcast is brimming with such talk and it’s starting to take a toll on investors. While investor sentiment can drive the bond market in the short term, economic fundamentals will be the ultimate harbinger of future prices and yields.
Regardless of whether or not you think the US Federal Reserve’s quantitative easing has had the desired, or any, effect on the economy, this was never meant to be a permanent solution. The implication being that the additional stimulus would have to be removed at some point. That this would likely occur only after some improvement in the economic well-being of the United States is not necessarily a bad thing.
Recent comments from US Federal Reserve President, Ben Bernanke, were the catalyst for a sharp uptick in bond sales, namely his suggestion that the Fed might begin reducing (aka tapering) their program of asset purchases this year. Reducing purchases is not the same thing as raising interest rates and investors need to understand this very important point. Bernanke said absolutely nothing about rate increases so why is everybody running for the doors? Furthermore, given that much of the economic data released in June was weaker-than-expected in both Canada and the US; central bankers are unlikely to move interest rates higher at this stage.
Addenda Capital, a leading fixed income manager in Canada, believes that investors reacted too strongly to comments from the Fed regarding future ‘taper’ plans. They further advise that central banks have been rather vocal about their commitment to keep rates low for the foreseeable future and in the US there is a widely-publicized target for the unemployment rate. Fears of a near-term increase in short-term interest rates appear to them to be quite overblown. And, they’re not alone in this belief.
Doesn’t it strike you as rather odd that tighter monetary policy could be around the corner when inflation is running below target in both Canada & the US, the economy [US in particular] continues to operate well below capacity, unemployment is high [US] and inflation expectations, by many accounts, are on the decline? How on earth can these conditions be construed as setting the stage for an interest rate tightening cycle?
The outlook for bonds is constantly evolving as new data is received, but the general consensus is that economic growth will likely remain sub-par here in Canada, keeping interest rates low. Meanwhile, in the US, until unemployment reaches or at least nears the 6.5% target, it’s unlikely that the Fed will raise rates. On the subject of tapering, the economic concept of supply and demand prevails, with the Fed forced to curtail its bond purchases for the simple reason that there will be fewer government bonds available for purchase. The US deficit is expected to drop sharply, which means smaller new issuance going forward. Again, we want to remind you that any decision to reduce purchases is completely separate from a decision to raise interest rates and from what the Fed has said thus far, it seems unlikely that this will transpire before 2015. That being said, higher volatility in the bond market is likely here to stay.
Fixed income securities still have a place in client portfolios, with the focus being on how they contribute to the goal of capital preservation rather than generating huge returns. In particular, higher-quality issues with timely and predictable return of principal and income will always form a solid part of any portfolio from an asset allocation perspective. Remember, if the rise in US interest rates is sharp or sudden, there is plenty of reason to believe that other asset classes will suffer greater losses than quality fixed income holdings.
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