Interest rates: Where do we go from here?

Oct. 17, 2022

The forces behind the retreat in both the equity and fixed-income markets are by now familiar to investors: Rising interest rates triggered by inflation that’s higher and stickier than expected, and a scramble by the U.S. Federal Reserve (Fed) to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold.

In that vein, the Fed recently increased it funds target range to 3.00% - 3.25%, its highest level since early 2008, and has signaled that more hikes are coming.

What now? Ultimately, inflation will determine the path of rates going forward. But here are questions and considerations for investors to keep in mind as they seek to understand the direction of Fed rate increases and its impact on their portfolios.

1. How much monetary policy tightening is already priced into the markets?

A lot. As the chart below illustrates, according to futures markets, many investors anticipate that the Fed funds rate will reach 4.5% by mid-2023, some 200 basis points (bps) higher than its current range of 2.25-2.50%.

Source: Bloomberg as of May 5, 2022; The Fed Funds futures contract is for June 2023. The Financial Conditions index combines yield spreads and indices from U.S. Money Markets, Equity Markets, and Bond Markets into a normalized index. It is a Z-Score that indicates the number of standard deviations by which current financial conditions deviate from pre-crisis (before July 2008) levels.

2. Is the economy responding to higher interest rates?

To a degree. A bellwether index of U.S. financial conditions has already dropped in response to this year’s spike in rates. Supply-chain pressures have begun to ease, and the strong U.S. dollar is disinflationary. Wages and shelter costs have continued to rise, though.

3. What will it take for the Fed to step back from tightening?

Weaker demand and lower inflation. Fed Chair Jerome Powell has said it would likely take several months of lower core inflation for the Fed to consider retreating from hiking rates. Rising unemployment or any hints of growth dipping below trend might cause the Fed to pause on rate hikes.

4. What could go wrong from here?

The Fed is in uncharted territory, given the gap between current inflation (over 8%) and the Fed’s 2% target. Moreover, the Fed’s use of quantitative tightening to pare back its balance sheet, simultaneous with outright rate hikes, is untested. While the Fed is hoping its rate hikes will bring down inflation with only “some pain to households and businesses,” a deeper recession is a possibility. On the other hand, if the Fed pulls back and the market doesn’t believe inflation is under control, the Fed’s credibility would be at risk.

Investor considerations

Here are three things for investors to consider in a rising-rate environment:

  • Don’t abandon fixed income at these levels. In an environment of decelerating demand and inflation potentially peaking, 10-year US Treasuries sporting an attractive yield represent decent value for investors and should provide some portfolio diversification if the economy slows, especially given the longer-term structural impediments to growth.
  • Consider diversifying fixed income exposure. Given the uncertain inflation outlook, committing too much capital to long-duration U.S. fixed income may be risky. Diversifying across global bond markets and currencies with flexibility to tweak portfolio duration as needed may be a better strategy. High-quality corporate bonds look relatively attractive as of this writing, as do short-term bond yields at today’s levels.
  • Quality is key for equities. Defensive sectors and dividend payers look likely to outperform the market amid elevated volatility as the Fed removes liquidity in the months ahead. Longer term, many investors are finding opportunities in high-quality companies with solid balance sheets and growing revenues and profits at potentially attractive entry points — including in less-favored sectors like technology and consumer discretionary.

How will inflation affect your portfolio?

If you’re wondering about the impact inflation will have on your portfolio, consider reaching out to your Ameriprise financial advisor. They can show you how the investment strategy you put in place together accounts for headwinds like inflation and market downturns and help make adjustments as needed.