Beyond Fed's (all but certain) rate hike

The most anticipated interest-rate hike since the Great Depression also might be the most irrelevant. But that doesn't mean advisers don't need to pay attention. If, as is widely expected, the Federal Reserve's monetary policymakers decide at their Dec. 15-16 meeting to raise interest rates for the first time since 2006, financial markets are fully expected to experience some immediate, but short-term, volatility. Stocks, which have benefited greatly from a Fed monetary policy that all but forced investors into riskier assets to boost returns, will likely suffer from a knee-jerk, risk-off reaction. And bonds, in general, are ex-pected to suffer from a similar panic that assumes a ripple-effect of higher rates driving down bond prices. The key for financial advisers will be the ability to look past the initial reaction toward a reality that, for the most part, won't be much different than it is the day before the Fed decides to raise rates. “We are talking about going from an ultra-accommodative monetary policy to an extremely accommodative monetary policy,” said Tom Nelson, senior vice president and director of investment solutions at Franklin Templeton.

STRONG EMPLOYMENT REPORT

In the wake of the surprisingly strong October employment report, released Nov. 6, projections based on futures-trading activity pegged the chances of a Fed hike in December to 70%. But that much-anticipated move off the zero-mark, where the Fed funds rate has been since the start of the 2008 financial crisis, is still only expected to amount to 25 basis points. Financial markets may very well react to the Fed's initial move, if for no other reason than it's taken the central bank so long to raise rates. But considering the stubbornly sluggish pace of U.S. economic growth, and the fact that virtually every other central bank around the world is lowering interest rates, there is little expectation that the Fed is on the verge of an aggressive rate-hike cycle.

SLOW PACE

“The pace of future interest-rate increases is expected to be extremely slow,” Mr. Nelson said. “This could be the most dovish tightening cycle we've ever seen, and we don't think interest rates will be materially higher than they are now even a year from now.” Considering three rounds of record-setting quantitative-easing programs that have saddled the Fed with a $3.7 trillion balance sheet that still needs to be unwound at some undetermined date, dovish might be the ultimate understatement. The Fed, which is obligated to conduct monetary policy based on a dual mandate of managing inflation and employment, has seen the unemployment rate drop to 5%, but depending on how inflation is measured, it is still well short of the Fed's 2% target. And then there's the stubbornly strong U.S. dollar, which will only gain strength if and when interest rates start to rise. A strong dollar is particularly troublesome for multinational U.S. companies that sell goods and services outside the United States. In essence, a Fed rate hike is a signal of a stronger economy, but that's not how it is likely to be interpreted. The outlook for how the Fed will follow its first rate hike — whether it happens in December or early next year — ranges from the purely symbolic “one and done” to mildly aggressive. The one-and-done scenario is as close as the Fed could get to the status quo, while still saving some face for having finally moved off of zero. In this camp, some argue that by raising rates even a measly quarter of a percentage point, the Fed at least has that much ammo to cut rates again if necessary. “The 25 basis points on its own is meaningless, but if it's taken as a genuine change in direction then it has implications,” said Bob Rice, chief investment strategist at Tangent Capital. The flip side is the prospect of a tightening cycle that is still deliberate by historical standards, but which could be interpreted as wildly aggressive in the context of the past nine years. “The Fed is not a one-and-done kind of institution; I think they will hike by 25 basis points in December, and then go up by 25 basis points at every other meeting next year, which will bring us to about 1.25% by the end of 2016,” said Paul Schatz, president of Heritage Capital. Mr. Schatz, who does not think a rate hike is needed at this time, believes the financial markets will not initially embrace the new monetary policy. “The markets will take some time to digest the certainty of higher rates,” he said. “Artificially low rates tend to dampen volatility, so we'll see more-volatile markets, which doesn't mean corrections, but daily and weekly ups and downs will be more severe.” Mr. Schatz anticipates a “vicious sector rotation,” where consumer staples, utilities and real estate investment trusts will face head winds and fall out of favor. “A rising-rate cycle is agnostic for technology, consumer discretionary and retailers,” he said. “And it's really good for banks and financials, because they will be able to make more on the interest margins.” But picking winners and losers in the rising-rate cycle requires, first and foremost, a rising-rate cycle. All one needs to do is glance at the nontraditional-bond-fund category to see how much an investor can suffer by playing too much defense at the wrong time. Largely promoted as go-anywhere strategies designed to navigate rising rates, there were just 31 nontraditional-bond funds totaling $12.9 billion at the end of 2009. Through September of this year, the category has grown to 128 funds and $145 billion. But after six consecutive years of net inflows, the category has seen $6.5 billion in net outflows through the first nine months of this year, suggesting that investors are growing tired of underperforming broader stock and bond categories while waiting for rates to rise. “These funds are marketed with the idea of unshackling the manager to be able to go anywhere, but they're mostly being used to guard against the bogeyman of higher interest rates,” said Morningstar Inc. analyst Eric Jacobson. He explained that nontraditional bond funds, in general, have been playing so much defense against rising rates that they've shown their vulnerabilities to the other primary bond risk: credit. In 2013, when interest-rate volatility was front and center, the nontraditional-fund category had an average return of 0.29%, compared with a 1.42% decline in the intermediate-term bond fund category. But in 2011, nontraditional-bond- fund managers were caught flat- footed as credit risk picked up and the category averaged a decline of 1.29% while the intermediate-term bond category gained 5.86%.

HIGH-YIELD BONDS

“As a group, these [nontraditional bond] funds correlate highly with high-yield bonds and equities, and they don't correlate positively with interest rates,” Mr. Jacobson said. “They will do well in a period of a short-term rate shock, but it's the periods in between where it will be more difficult for them to do well with very short or even negative durations, because they're trading off interest-rate risk for credit risk.” And it all might be for naught. Robert Tipp, chief investment strategist at Prudential Fixed Income, believes the Fed will probably raise rates nominally next month, but he also believes the bond market has already factored that in. It is a mistake, he said, to look in the rear-view mirror and try to navigate an unprecedented monetary environment based on history. Over the past 20 years, for example, the average yield on the 10-year Treasury has been 4.2%. Today, it's 2.3%. “Equities have had a great recovery, and the bond market has seen yields drop to some of the lowest levels we've ever seen,” Mr. Tipp said. “Investors are confused as to where to look for a reference point, because against that backdrop people are anxious that yields will go up and they will lose money in bonds.” But the bigger picture looks quite different when the 10-year Treasury is stacked against the comparable German bund, which is yielding 0.83%. That 1.5-percentage point spread ranks in the 99.7th percentile of the widest spreads between the two bonds over the past 20 years. And it ranks in the 99.9th percentile of the widest spreads over the past 10 years. “I think rates have already risen, and it's already priced into the bond market,” Mr. Tipp said.