Preparing for an Interest Rate Increase

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Feb 25, 2015
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The Federal Open Market Committee recently released its January 27-28 meeting minutes, which included more detailed insight into the economy’s growth and the FOMC’s outlook for future interest rate hikes. The minutes addressed its key indicators including inflation and employment. It also noted improved 2014 economic indicators which have continued to guide the FOMC towards a federal funds rate increase in 2015.

The January meeting and FOMC minutes continued to focus on price stability and maximum employment. The FOMC reiterated its inflation target rate of 2%. Prior to the January FOMC meeting, the inflation rate appeared to be stabilizing at 1.25%; however, February’s reading showed the inflation rate dropping to 0.7%, according to the Commerce Department, as lower energy prices drag on US prices.

The Feds take on the January employment rate was that the topline numbers are improving shown by an upward revision in prior month payrolls and improvement in the unemployment rate to 5.6%. While the unemployment rate and topline nonfarm payroll increases alone don’t tell the whole story, the improvements in 2014 are enough to keep the FOMC on track for a rate increase.

In its January meeting minutes, the FOMC outlined the technical mechanisms it would begin to use within the SOMA account for manipulating the rates away from their current level of zero. The minutes noted the FOMC’s intent to primarily use reverse repurchase agreements and overnight reverse repurchase agreements when manipulating the rates.

While the Fed has begun to test its mechanisms for a rate increase, many speculators believe that a rate increase will not be implemented until the second half of 2015. The Fed will likely initiate a fed funds rate increase at a meeting that includes a public press conference, which would be its March, June, September or December meeting. Many investment gurus have noted that a rate increase is imminent in 2015, pushing investors to focus more on the amount of the increase and the peak level that the rate could be increased to over the longer-term.

Warren Buffet discussed his outlook for the economy in a February talk with Fox Business. In general, he thinks the rate increase will be difficult to time given the global pressures the FOMC must battle. He and other investment gurus are also emphasizing the implications for the dollar and how the higher borrowing rates would affect equity valuations. Specific affects are likely to include continued dollar strengthening and higher capitalization rates which would deflate earnings.

Following the January FOMC meeting, the Dow was up 1.31% on January 29 and after the release of the FOMC meeting minutes, the Dow was down 0.24% on February 19. Year to date the Dow Jones Industrial Average is up 2.17% with stocks Boeing (BA, Financial), Pfizer (PFE, Financial) and UnitedHealth Group (UNH, Financial) leading the way. Speculators expect valuations of smaller companies to be the most significantly affected by a rate increase since the easy money policy has allowed them to gain access to credit at much lower rates. Year to date the small cap Russell 2000 index is up 2.43%.

In fixed income, Mark Hulbert recently provided insight on market positioning in his article, “Here’s the Income Portfolio You Want to Own When Interest Rates Rise.” Hulbert suggests investing in intermediate term bonds with a disciplined reinvestment strategy that allows investors to gain from rate increases and offset value decreases.

This week, Janet Yellen will continue the interest rate discussion in her testimony before Congress ending on February 25. Yellen will be providing more detail on the FOMC’s economic outlook and plans for a rate increase. Investors should continue to watch for insight on incremental rate changes and the peak level in which the federal funds rate will increase to over the next year.