- An interest rate increase is hanging in the air but no one seems to find enough reasons to pull the trigger.
- The FOMC expects inflation to be at 2% and interest rates at 2.6% by 2018.
- Holders of long-term bonds might rethink their positions as interest rate increases could have severe negative repercussions on bond prices.
On May 18 the FED released the minutes of the Federal Open Market Committee (FOMC) meeting held in April. The FOMC decided not to increase interest rates in April which gave a short relief to the markets, but an analysis of the FOMC meeting minutes reveals interesting things because it gives indications on the way of thinking FOMC participants have and hints on potential future interest rate increases. While the goal of the FED is to maintain financial stability and increase the resilience of the financial system to shocks, for an investor it is important to look at the economic trends related to the FOMC’s decisions in order to better assess the risks of their portfolio.
The Minutes in Segments
There are several important take-outs from the minutes that are interesting for investors. The minutes start with a big warning—more like a disclaimer—saying that the FOMC can make errors as many of the macro-prudential tools used or available to be used are untested. Untested tools combined with the FOMC’s goal of keeping the economy growing at full employment with stable inflation might be dangerous as it can create imbalances in the financial and economic systems.
The economic information used by the FOMC that brought it to the decision not to increase interest rates was that labor conditions improved but GDP growth slowed, inflation is still below the target of 2%, payroll employment expanded bringing a 5% unemployment rate, part-time employment remained flat and job openings declined slightly but are still at an elevated level and manufacturing decreased reflecting the appreciation of the dollar. One piece of information that changed since the meeting is new housing starts which were down in March but it picked up in April by 6.6%.
Domestic economic releases had a limited effect on asset prices that, alongside market accommodating FED communications, improved the risk sentiment. Nominal 10-year treasury yields declined, and the volatility index (VIX) decreased while stocks went up even though corporate earnings have been falling.
While the situation in the economy might be looking—and the markets looked—stable before the meeting, the stock markets did not react that well to the minutes, anticipating an increase in interest rates in June. It is interesting to see that the FOMC’s financial market overview is a bit larger than the economic overview which sends a mixed message as it is not clear if the economy or market prices are more important.
The FOMC expects GDP growth at a moderately faster pace than potential output supported by consumer spending. The unemployment rate is expected to decline further and to reach the natural rate. Inflation is still expected to rise and reach 2% in 2018 from the current 1%. Participants still expressed concerns over the outlook as the current decrease in domestic spending might decrease due to global economic and financial concerns. Business fixed investments declined but participants had mixed opinions as growth in some districts gives positive inputs.
The FED decided not to increase the interest rate as weak readings on spending and production, and below target inflation still create some concerns. Thus they decided that it is prudent to wait. In relation to future rate increases, the FOMC will continuously monitor economic data and make further decisions from there.
Implications of Next Meetings
Since the FOMC meeting in April, positive news came out as new housing starts increased which suggests that an interest rate increase might be around the corner for the June meeting. Bond yields immediately increased and bond prices fell. But the potential interest rate increase has mixed effects for investors. An interest rate increase would indicate an improving economy, but at the same time have severe implications on interest expenses for corporations. Higher interest rates would also mean a stronger dollar which would further affect the already declining exports and manufacturing.
Investors in long term bonds should assess their risks properly as if interest rates increase, bond prices decline to match the increased yields. The US 10-year treasury bond yield is still around three year lows with a yield of 1.86%, but is significantly higher than the low of 1.52% reached in February.
Figure 1: US Ten Year treasury note in last 3 years. Source: Wall Street Journal.
If the interest rate increases are moderate, bond holders will lose some money on longer term bond prices but will gain on higher interest payments. But, low interest rates do not give much hope that the coupon payments will be high enough to cover the loss in value as a yield increase of 1 percentage point would decrease the bond value by almost 33% at these levels.
In the longer term, the FOMC expects to set the interest rate at 2.6% by 2018 when inflation is 2% and full employment is reached. According to Goldman Sachs, stock markets tend to drop by 10% when tightening cycles start. Higher interest expenses would further push down corporate earnings and have a negative effect on the stock market.
A potential good diversification and hedge against higher interest rates are banks as they are the ones that profit the most from higher interest rates. Higher interest rates in combination with a better economy should increase mortgage rates so home buyers should not wait much longer as interest rate increases are almost certain, though no one knows when.
The FOMC minutes seem like the weather before a summer storm, and there is a feeling that something is coming but no one knows when. Warren Buffet puts it nicely by saying: “So far, I have been wrong on interest rates. It is so hard for me to believe that you can drop money from a helicopter and not have inflation, but we haven’t.”
It looks like the FOMC is anticipating inflation or having the same disbelieve but hesitating to increase interest rates as the economy has not yet reached its full potential. Such a situation is uncharted territory and therefore it seems that no one knows exactly what is to be done, so a wait-and-see strategy prevails. Perhaps a wait-and-see strategy is the best one also for investing; following Buffett who mentioned several times that he invests no matter what the FED does and that knowing what the FED would do in the next year would not change his investment decisions.