Portfolio manager and senior investment strategist parse Fed's language, unpack equity and fixed income implications
Yesterday, the US Federal Reserve took its turn at the rate-holding game, effectively keeping the benchmark federal funds rate between 5.25% and 5.5%.
The US is seeing its highest interest rate in 22 years as a result of Fed officials’ efforts to tame runaway inflation. From its June 2022 peak of 9.1% this cycle, inflation has moderated to 3.7% – definite progress, but still off from the 2% price stability target policymakers have sought to maintain.
The Fed’s November non-move was no surprise to Travis Forman, portfolio manager at Strategic Private Wealth Counsel (pictured above, left).
“The rate pause is the second time in a row that the Fed elected to maintain the overnight rate as the economy continues to take on the effects of inflation in addition to higher borrowing costs, while monitoring employment figures and other key GDP indicators,” Forman noted in an emailed statement to Wealth Professional.
The hold decision was apparently not a contentious one either at the round table of the Federal Open Market Committee (FOMC), with all 12 members voting for it. Even looking at his Bloomberg terminal in the morning preceding the announcement, Bilal Hasanjee, senior investment strategist at Vanguard Canada, could see it was a foregone conclusion as stock prices moved higher and bond yields edged down.
“The FOMC has highlighted the emergence of ‘tighter financial and credit conditions,’ which is a change from their prior mention of only tighter credit conditions,” Hasanjee (pictured above, right) told WP by phone. “This adjustment in language may suggest that the recent increase in long-term Treasury yields could reduce the urgency for the Fed to implement further rate hikes.”
As Hasanjee notes, Federal Reserve Chair Powell has gone on record saying the recent rise in long-term Treasury yields would need to be persistent to take the place of rate hikes. While that’s not the prevalent forecast in the market today, many analysts’ estimate such a rise would be equivalent to 25 to 50 basis points of hikes.
The Fed’s announcement also referenced “a strong pace” of expansion in US economic activity during the third quarter, in contrast to its previous description of “solid” economic growth. Another notable change in language, Hasanjee says, pertains to how job gains have “moderated since earlier in the year but remained strong,” whereas before it said hiring has been continuing but has weakened.
Stock markets inched higher immediately after the announcement, says Hisanjee, with the TSX rising by 0.55%; the S&P and the Dow each rising by about 0.7%, while the Nasdaq went higher by 1.4%. Since July, he says 10-year US Treasury yields have risen by more than 100 basis points; both US and Canadian 10-year yields were at 16-year highs, which has brought down equity valuations “quite a bit.
“Vanguard’s view is that equity valuations have come down and that has improved our median expected returns [on equities] over the next 10 years,” he says, noting the firm’s 10-year return expectations on Canadian equities have improved by more than 50 basis points from the end of June to the end of September 2023. During that same timeframe, the firm’s 10-year expectations for international equities increased by about 0.6%.
“Long-term return expectations on bonds have improved quite remarkably over the past three months, for both Canadian and global bonds, by about 80 basis points due to a rapid rise in yields recently,” he says. “Long-term yields have started to subside; for 10-year yields in Canada, it went down by about 11 basis points, and for the US 10-year Treasury, it declined by about 15 basis points, after the Fed decision.”
If yields on long-term Treasuries continue to decline, Hasanjee says investors should consider locking in long-term bond yields, assuming it fits with their overall investment objectives.
“This is a time for investors to lock in high yields while they persist, because once the Fed starts to cut, these yields will come down pretty quickly,” he says. “In our opinion, this is a good time to be in bonds and dial down portfolio risk by increasing the tilt towards bonds in the portfolio if it fits well with the investors’ goals. This is a good opportunity on the equity side as well because over the past three four months, equity valuations have subsided quite a bit.”
Even with the fastest series of rate hikes in four decades, Forman said future increases are not out of the question as the Fed leaves an opening for one more in 2023. Against that backdrop of policy uncertainty, the 10-year Treasury Yield, a key benchmark influencing rates on consumer debt, has surged to a 16-year high over the past month, briefly eclipsing 5%.
“On Monday, the Fed said it would auction off US$1.5 trillion worth of debt over the next six months,” he said. “By issuing more debt, investors should expect more volatility both in the bond market and equity market.”
Should the US central bank decide to hike, it should do so with caution. Hasanjee says both the Bank of Canada and the Federal Reserve are now having to execute a delicate balancing act.
“On one hand, they have to bring the inflation genie in the bottle, but at the same time, they want to ensure that they do not cause unnecessary stress in their respective economies, or trigger a deep and prolonged recession,” he says.
“But the Bank of Canada may have lower flexibility than the Federal Reserve in terms of hiking rates further, because of the high indebtedness of average Canadians,” Hasanjee adds. “High mortgage rates have impacted Canadians’ balance sheets … It may have an impact on the economy if the [BoC] keeps hiking rates further.”
