Interest-Rate Hikes and Bonds | Adviser Investments

The End of Interest-Rate Hikes: Are We There Yet?

Man researching the Fed's interest-rate strategy to determine the likelihood of another rate hike

Curious bond investors everywhere want to know: Are we there yet? “There” refers to the end of the Federal Reserve’s interest-rate-hiking cycle. It’s not a certainty, but our view is that the Fed is on the cusp of shifting policy.

The economy may be weakening, which supports this view. Softening data from areas including retail sales, GDP, initial jobless claims, job openings, the service sector and home sales all point to slower economic growth.

The Fed is close to the end of the rate-hike cycle

• The end of hiking doesn’t mean the Fed will immediately begin cutting interest rates
• Inflation is slowing, but it’s not gone
• A period of higher rates benefits bond investors by providing more time to reinvest dividends and interest at attractive levels
Inflation continues to be a thorn in the Fed’s policy side, however. The consumer price index’s decline from a peak of 9% in June 2022 to just under 5% in April is evidence that the Fed’s effort to cool the economy by raising interest rates is working. But 5% is still too high, meaning the Fed may need to do more.

In particular, inflation’s “sticky” components—the cost of recreation, personal care products, medical care and certain other categories of spending—have not eased as much as the headline number. Higher prices in these areas are supported by the strong job market, which props up consumer demand. Winning the inflation battle through monetary policy will take more time.

But that doesn’t require the Fed to hike rates continually. It can combat the problem by maintaining the current level of rates. Typically, when borrowing costs are high, consumers borrow less and spend less. That results in a drop in demand that is followed by a drop in the cost of goods and services. By leaving rates where they are, the Fed can passively work to cool the economy further. This is where the “higher for longer” policy comes in.

Table shows yields for a variety of bond market benchmarks as of 4/30/22 and 4/30/23. Over the period, yields have risen.
Source: Bloomberg

So, what happens next? Like many investment markets, the bond market can be forward-looking, and in this case, that applies to where rates are headed. Many analysts believe the Fed will cut interest rates before the end of 2023. It may do just that, but we think it’s unlikely with the current level of inflation. Barring a bigger problem within the banking sector or any other major economic event, we believe a more likely scenario is that the Fed will stop hiking and stand pat.

The takeaway for investors is that some yields are lower than they were in Q4 last year, but they remain rewarding compared to where they were a full year ago, as illustrated in our data box above. And if you’re reinvesting dividends and income, a policy of higher rates for a longer period will benefit you because you are buying new bonds (or bond fund shares) while they are offering higher yields.

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