When Rates Rise, It Probably Won't Be in Alarming Fashion

Understandably, advisors likely need a respite from all the interest rate talk and we're only halfway through the year. It doesn't appear the Federal Reserve wants to accommodate.

Last week, the minutes from the Federal Market Open Committee's (FOMC) June meeting revealed – the details residing in the “dot plot” – that some Fed members believe 2023 will be appropriate for a rate hike. As recently as March, no Fed governors felt that way, indicating that 2024 would be the earliest a rate hike would arrive and let's be honest. That's a presidential election year and the Fed usually eschew rate hikes in those years.

While it's not a foregone conclusion that the Fed will raise rates in 2023, the realities are that the central bank is reiterating its stance of data dependency and that the current paces economic recovery and government spending could move a 2023 rate increase to the “necessary” column from the “optional” category.

In other words – and advisors know this already – it's a good time to start preparing for the specter of an official rate hike and some asset classes that offer that preparation are appropriate today and will be durable regardless of Fed plans.

Expect Modesty

An avenue in which advisors can add value – and it's a movie they've previously starred in – is to calm clients regarding rate hikes. As noted above, clients have the benefit of time. In this case two years. Additionally, advisors have an extensive toolkit with which to position client portfolios to survive and thrive when the Fed finally tightens.

Still, some clients love to read the headlines and do their homework – pursuits advisors should encourage – and some are likely to come away pensive about the aforementioned dot plot positioning. Advisors can ameliorate this scenario by telling them rate hikes by the Fed and other major central banks are likely to be of the modest variety.

“We expect balance sheets to remain large relative to history, however, because of structural factors, such as a change in how central banks have conducted monetary policy since the 2008 global financial crisis and stricter capital and liquidity requirements on banks,” writes Vanguard's Alexis Gray. “Given these changes, we don’t expect shrinking central bank balance sheets to place meaningful upward pressure on yields. Indeed, we expect higher policy rates and smaller central bank balance sheets to cause only a modest lift in yields. And we expect that, through the remainder of the 2020s, bond yields will be lower than they were before the global financial crisis.”

The Fed's benchmark rate currently hovers around 0.25% and Vanguard forecasts it will take until 2025 to move that up 100 basis points and it will be 2030 by the time that 1.25% doubles to 2.50%.

“Our view that lift-off from current low policy rates may occur in some cases only two years from now reflects, among other things, an only gradual recovery from the pandemic’s significant effect on labor markets,” adds Gray.

Bond Musings

One area of preparation advisors can discuss with clients prior to Fed tightening is one they're likely engaging in: Strategies that can thrive in the face of rising rates.

This an important conversation because in Vanguard's base case reflation scenario, 10-year Treasury yields could hit 3% by the end of this decade. If the recovery runs too hot, that figure percentage could jump to 4%. Again, that's keeping with the theme of modestly and that should be enough to help clients keep calm and carry on.

“Our base-case forecasts for 10-year government bond yields at decade’s end reflect monetary policy that we expect will have reached an equilibrium—policy that is neither accommodative nor restrictive. From there, we anticipate that central banks will use their tools to make borrowing terms easier or tighter as appropriate,” concludes Gray. “To any extent, we expect increases in bond yields in the several years ahead to be only modest.”

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