All Eyes on the Fed

This below post was originally disseminated to clients on 6/3/16. Since then, economic data has come in softer than expected and the odds of a June or July Fed rate hike have dropped precipitously. Long-term rates have also dropped sharply and reinforce our defensive posture.

All eyes remain on the Federal Reserve, as investors weigh the probabilities of future interest rate hikes. Beyond all the headlines, it is important to remember that the Fed only has two main goals (called “the dual mandate”): price stability (read: inflation) and maximum employment. Today’s data shows that inflation is turning up as we expected it would and employment data continues to improve at a healthy clip (although this morning’s data was not great). Overall, these are positive economic signs, but they are also the specific ones that the Fed watches and thus keeps the threat of an imminent Fed rate hike alive.
          We are cognizant that the most recent rate hike in December preceded a decrease in long-term interest rates. One popular explanation is that the US economy cannot handle rising short-term rates, which has caused longer-term economic prospects (and corresponding interest rates) to decline. This is possible, but it is also important to note that decline in long-term rates coincided with high volatility in global financial markets. Thus, while the negative correlation between short- and long-term rates could continue, it is not a given (or even probable for that matter). With rates at extremely low levels and credit spreads well below their February highs, our fixed-income orientation is shifting from offense to defense.