Interest rate hike in September or December?

Posted on: 09/10/2015

Although the timing is variable, we agree with the Fed Funds futures market that the first Fed rate rise will take place in December.  Given the global economic slowdown, the Fed does not want to import economic slowing to the U.S. by raising rates too early.  On the other hand, unless a massive U.S. economic slowdown is evident, the Fed wants to be on record that they started normalizing interest rates in 2015.

More importantly is the number of increases in the Fed Funds rate in 2016.  Currently, the Fed Funds futures contracts expect 25 bps increases in March, September and December.  We think this is too aggressive of a schedule for the following reasons:

  • If they can help it, the Fed will not increase interest rates in September since it is too close to the Presidential election in November. They have been accused by Presidential candidates of favoring one side or the other in past elections (see here if you want an exhaustive treatment on the subject.)  Thus, it is likely that only one or two interest rate increases will happen in 2016
  • March may be too early for the first 2016 rate increase, especially if the initial increase in 2015 happens in December.  Thus, the March increase could be moved to June
  • The December increase will wholly depend on the economic reactions to the previous increases.  If the U.S. economic growth continues or strengthens through 2016, the Fed could increase rates then.  If the economy is having troubles, they will wait until 2017.
  • In summary, the Fed will increase interest rates no more than 2 times next year compared to the 3 times expected in the futures market and these increases may happen later in the year than currently expected.  Both of these possibilities are positive for Treasury bonds.

Although there will be short-term psychological effects, there will not be significant market moves if the Fed increases rates in December.  3rd quarter earnings, that will recover from the 2nd quarter year-over-year declines, will be known and the consensus for the rate increase should be near universal.  A rate increase in September may result in more volatility in the equity markets.  Given minor amounts of 3rd quarter macroeconomic data and no 3rd quarter earnings data released by then, it is likely that there will be no consensus on a September rate increase if it is implemented at that time.  Also, a September rate rise will increase the number of rate rises expected in 2016.

Over the long-term, Post-MPT Allocation investors should be served well by the strategy.  If short term interest rates rise at a slow to moderate rate, earnings increases should still be strong, especially in the sectors with strong balance sheets (such as health care and technology), which will allow the strategy to outperform standard equity indices.  If interest rates rise at a fast pace due to inflation fears, the ability to own gold stocks and REITs and to not own Treasuries, utilities and other interest rate sensitive sectors should also lead to attractive returns.

The Post-MPT Allocations have begun to reflect the above analysis.  In late June, the amount invested in long-term Treasuries was significantly increased.  This was at a time when the futures market was leaning toward 4 increases in 2016.  In essence, the model behind the Allocations was indicating that the expected returns from long-term Treasuries were attractive compared to that of equities.  Although long-term interest rates have declined (bond prices increased) and the number of expected Fed Funds rate increases has dropped since late June, the model currently indicates that long-term Treasuries are still attractive compared to equities.  In any case, the strategies are more diversified now then they have been for over two years.  Also, Post-MPT Growth is at its lowest leverage since 2013.  Both of these portfolio structures should serve us well if we have a volatile equity market in the coming months.

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