Baird's Experts Weigh in on What the Rate Hike Means for Investors

December 21, 2015

On December 16, the Federal Reserve raised interest rates by 0.25% – the country’s first interest rate hike in nearly a decade. Baird sat down with Senior Fixed Income Analyst Craig Elder and Investment Strategist Willie Delwiche on how this widely anticipated announcement could impact the equity and fixed income markets, and what it means for investors.

Baird: Craig, how do you expect the Fed’s decision to raise interest rates to play out in the fixed income market?

I think we'll probably be around 2.75% on the 10-year by mid-year, up to 3% by the end of the year. When I say 2.75%, it might not necessarily be a smooth path. There will be some volatility there. Come 2017, potentially after some additional rate hikes, I could see interest rates beginning to impact housing. 

Baird: Willie, what about the equity market? What impact does this announcement have on stocks? 

Ultimately the Fed’s decision speaks to their confidence in the economy, which translates into investor confidence in the Fed’s path going forward, and that’s good for stocks. If the Fed were worried about significant weakening in the economy, they would not do this – it would be more damaging to their credibility to do a one-and-undone approach than it would've been to pass.

I think that confidence in the Fed will last until there's an inflation report that shows inflation either picking up or falling apart. Then, you'll be back in the soup with, “Are they behind the curve?” or “Should they not have done it?” Probably not to the same degree as what we've seen in recent months, but just as Craig talked about volatility in terms of bond yields, I think we’ll get the same thing in terms of the stock market. 

Over the long term, I don't think the Fed acting will be a big driver for stocks next year. There will be lots of other noise that can take that place.

Baird: Did the press conference after the meeting provide any additional insight into what the Fed is planning?

I think it came off like they wanted it to – taking a measured approach that did not scare the markets. The yield on the benchmark 10-year treasury only moved one basis point higher. That's exactly what the Fed was looking for in telegraphing this move.

The Fed’s dot plot, also know as their consensus forecast, shows that we’ll have four additional interest rates hikes in 2016. There’s a possibility they could do one at each meeting that is followed by a press conference, but we’ll have to wait and see. However, the markets are not convinced we will see four moves.

In reality, the Fed is not really pressured to move at this point. Look at the economic projections for the next several years: The inflation number they use, the core PCE number, has been running at 1.3% for several months. They're projecting it to hit 1.6% next year and 1.9% in 2017, with a target of 2% in 2018. They've got unemployment bottoming at 4.7% next year and staying there through 2018. They’re projecting GDP growth to slow to 2.4% next year, 2.2% in 2017 and 2% in 2018.


Baird: You’ve noted that the Fed will be watching inflation numbers among other indicators going forward. In determining whether they will move again in March, what will you be dialed into?

I'm looking at that core PCE number for inflation and the GDP number. 

I would add to that the payroll data. They put a lot of impact on payrolls. Within payrolls, I think more than the jobs number itself is wage gains. We're starting to see some wage growth pick up. If that continues, then that will be one of those inflation indicators that says, "Okay, we’ve got to tighten a little – in line with what they expect, but a little bit more aggressive than what the market is currently pricing in."


Baird: What advice do you have for investors who may be wondering how to react to this news?

In the bond market, if you’ve done your asset allocation model correctly, you stay the course at this time. There’s nothing here that requires a great deal of change. The same rules apply: You don’t chase yield, and you don’t take extra credit risk. Stay the course and follow your asset allocation model.

Over time the long end of the curve will drift higher. We like variable-rate issues such as step-up agencies because it gives you some downside protection. We also like preferred stock fixed-to-floating rate issues, which have been less sensitive to interest rate increases. Still, you ladder your bond portfolio and over time everything seems to even out. Of course, individuals in a high income tax bracket need to be in municipal bonds as individual income tax rates are not going down any time soon.

Remember, it's only 25 basis points off of zero. It's not really a game-changer in terms of allocation. I will say that I think we’re at the point where if the equity market gets into trouble, the Fed won’t necessarily come in and add more liquidity and be more supportive. They're not going to raise rates but then say, "Oh yeah, things are getting a little volatile, so we need to do something."

I think cash is the under-owned asset right now and I think that will be a useful thing to have come midyear. When you have volatility and illiquidity, cash is what you want. I think those who have it will benefit.

It’s also worth remembering that a slow tightening cycle is not an impediment to stocks. There's the idea that if the Fed starts raising rates, then that must immediately kill of any prospect of stocks rallying. That's only if they do it fast. If they do it slow, you'll get a little bit more volatility than in a non-tightening mode, but it's not an overall headwind.

Baird: What do you think success will look like to the Fed? 

I think if we get inflation around 2%, and we have signs of growth and stable growth – not quarter-to-quarter fluctuations in growth, but a stable trend in growth – then that's success. That monetary policy has brought us back from the brink, and then we can look at more fiscal policy avenues for really rebuilding productivity growth and improving long-term growth trends.

We came out of an extremely steep recession in 2008, and if it hadn't been for the Fed, we would've been in a deep depression. We had a lot of leverage in the system and it takes a long, long time to recover from that. When you look at it, you see why the Fed needed to be so aggressive coming out of the recession.

Europe, on the other hand, did not take the same actions we did until much later, and you can see the problems they are having. We probably are in a path like this maybe for the rest of this decade. I see the Fed taking steps to lay good groundwork for future growth.