Brian Erickson, Vice President of Fixed Income Research and Strategy, Ameriprise Financial
- With the appointment of new Fed Chairman Jerome Powell, the Federal Reserve is under new leadership
- Investors are anxiously watching to see if the Fed will pick up the pace of raising interest rates
- Yields are likely to rise, a potential plus for investors but a burden for borrowers
A new season is sweeping through the Federal Reserve (the Fed), keepers of the nation’s monetary policy, and I am not referring to winter’s colder temperatures. Rather there’s a change of leadership and a surprisingly large slate of new members on the Federal Open Market Committee (FOMC) – the Fed’s primary policy committee.
Currently, only five of 12 voting members have been on the FOMC for at least one year. The high level of turnover results from a combination of retirements from Fed positions and Congress’ unwillingness to approve some nominees from the previous administration. This is an unusually rapid transition for an institution where each member of the Board of Governors generally serves a 14-year term.
The Federal Open Market Committee
The FOMC consists of 12 voting members from two groups, the Federal Board of Governors and the 2018 regional Fed presidents who are voting members. It is notable that the majority of the voting seats are currently open or filled by new members.
Yellen is out, Jerome Powell takes over
Jerome Powell is taking the reins as the new Fed Chair, replacing Janet Yellen, whose term as Fed Chair just ended this February. New leadership, combined with the high vacancy rate among the Board of Governors and the annual voter rotation of regional Federal Reserve bank presidents, give the Fed’s policy-making body a new look.
So many new faces could transform how the Fed approaches monetary policy and potentially how investors think about investing should, for example, the interest rate environment be affected.
Will slow and steady Fed interest rate changes continue?
The Fed began raising its key interest rate, the Fed funds rate, in 2015 and has proceeded at a measured, yet steady, pace ever since. Last October, the Fed began reducing its balance sheet of assets (such as Treasury bonds) accumulated through four rounds of quantitative easing.
This was an unprecedented program where the Fed became one of the largest buyers of bonds in the open market in an effort to help stimulate a struggling economy after the financial crisis of 2008. The Fed’s reduction of its bond holdings is likely to continue until at least 2020 and perhaps beyond.
The new slate of monetary policymakers will shape the path for policy going forward. We believe the Fed will hike the Fed funds rates three more times this year, shrink its balance sheet as planned, and begin to outline what a normalized Fed policy should look like going forward.
So many new faces at the Fed could transform how the Fed approaches monetary policy and potentially how investors think about investing.
Potential benefits for investors in short-term securities
As a result of the Fed’s anticipated actions, we believe short-term and cash investment yields are likely to move higher in the year ahead as Fed policy unfolds. The return of at least modest yields on these instruments proved to be an oasis for investors in 2017 after nearly a decade traversing a virtually yield-less desert. Investors are likely to see a rise in short-term yields depending on their choice of savings vehicles.
We recommend investors seeking to preserve capital look to short-term government securities, which may finally offer the potential to generate yields that keep up with the pace of inflation. Assets designated as emergency funds could see balances modestly increase as yields step higher. Finally, fixed income investors should expect portfolio yields to move higher as they reinvest maturing or liquidated securities or make new purchases.
Loan costs could rise
This scenario is less appealing for borrowers. Rising short-term yields could raise floating rate borrowing costs on home equity loans, floating rate mortgages, and other loans tied to benchmarks such as London Interbank Offered Rate (LIBOR) or the Prime rate.
The Fed’s long-standing low interest rate policy made money more easily available as a way to encourage consumers and corporations to borrow and potentially spur growth. We see that trend slowly fading as the Fed pulls back from its efforts to stimulate economic growth. Although consumers may pay a little more to borrow, we believe a range of options remain sufficiently available for the foreseeable future.
Our view is that the winds of change at the Fed could bring a mixture of positives and negatives for investors, without derailing markets in 2018.
A less predictable environment may be at hand
After five years of low volatility that generated solid returns for investors, we believe that the Fed’s retreat could usher in a new period of higher volatility for fixed income markets. This could result in a reassessment of valuations for various types of securities and create opportunities in select markets.
We view this as a healthy dynamic in an environment supported by a protracted economic expansion. All told, our view is that the winds of change at the Fed could bring a mixture of positives and negatives for investors, without derailing markets in 2018.