Barring a total economic disaster, the U.S. Federal Reserve Board is likely to begin raising interest rates later this year, perhaps as early as September. That, combined with fears of a China-led global economic slowdown, has rattled markets and resulted in the steep selloffs over the past week.
Fed chair Janet Yellen said in a speech earlier this year in Providence, Rhode Island, “If the economy continues to improve as I expect, I think it will appropriate at some point this year to take the initial step to raise the federal funds rate target.”
This comes as no surprise, of course. The Fed has been signalling for months that it wants to break out of the near-zero rate environment that has prevailed since the financial crisis of 2008. It’s been called the most choreographed rate hike in history.
The only thing that’s delayed it has been the stubborn refusal of the American economy to start functioning on all cylinders. According to the Department of Commerce, revised figures show the American GDP increased by a marginal 0.6% in the first quarter. The harsh winter, strong U.S. dollar, weak consumer spending, and slow global growth all bore a share of the blame for the weak result.
The Fed believes that performance was an aberration, caused by what Ms. Yellen referred to as “transitory factors,” and that the economy will strengthen significantly over the rest of the year. And in fact preliminary numbers showed the economy grew at an annual 2.3% in the second quarter. If everything unfolds as expected – and remember that economic forecasts are constantly being revised these days – the rate hikes will start this fall.
So what happens when they do? Here’s what to expect.
A gradual approach. There won’t be any sudden spike higher. The Fed will move cautiously, with a close eye on market reaction. The initial hike will only be a quarter-point, and then the Fed may pause for a few months to assess the impact. The last thing Ms. Yellen and her colleagues want is to create a new financial crisis or a exacerbate the stock market plunge. It will probably take a few years before interest rates return to historic levels – if they ever do. In March, Fed officials reduced their median estimate for where the rate would stand at year-end to 0.625%. Based on Ms. Yellen’s latest remarks, I think 0.5% is more realistic.
A stronger U.S. dollar. The last thing the U.S. needs right now is further strengthening in their dollar. The high greenback is already costing multi-national U.S. companies billions of dollars in lost profits and making American goods less competitive in foreign markets. A Fed rate hike will make the greenback even more attractive to offshore investors seeking a safe haven, driving the currency higher. That’s another reason to tread carefully.
A weaker loonie. The Bank of Canada won’t be able to match the Fed’s rate increase. Our economy is much more fragile due to the chaos in the energy sector as a result of the plunge in the oil price. In fact, there is still speculation that our central bank may decide to cut another quarter point to stimulate growth. A rate hike is nowhere in sight. In this scenario, the loonie is almost certain to decline when the Fed finally moves. Only an unexpected rebound in the price of oil could change that, and that looks highly unlikely.
Stock market disruption. Wall Street stocks fell in response to Ms. Yellen’s remarks. And in the past week they’ve fallen off the cliff. There’s already been a pattern of volatility for several months – stocks rise on suggestions the rate hike will be delayed and fall when news reports suggest the increase is coming soon. If the Fed stays on its current course, expect a continued market downtrend as the target date approaches. By the time the Fed actually moves, the market should have fully compensated for it.
Weakness in interest-sensitive stocks. Utilities, straight preferred shares, REITs, and similar securities will feel the main brunt of a stock market downturn. Unfortunately, these are the types of securities owned by income-oriented investors. We had a taste of this phenomenon about a year ago when premature speculation about a Fed rate hike ruffled the markets. You can expect a repeat in the coming months. The securities that should be least affected are those with a strong history of regular dividend increases.
Falling bond prices. Rising rates translate into lower bond prices. It’s one of the basic axioms of investing. The process has already started even though the Fed hasn’t moved yet. The yield on the benchmark 10-year U.S. Treasury bond has jumped from 1.88% at the start of the year to 2.05% as of the close on Aug. 21. Prices have fallen accordingly. The Bloomberg U.S. Treasury Bond Index hit a high for the year of 125.26 on Feb. 2. It finished on Aug. 21 at 123.84.
So how should you respond to what’s coming? Here are my suggestions.
Don’t panic. It’s important at this stage in the cycle to maintain perspective and remember why you own the securities you do. As long as the cash flow continues, income investors should not be overly concerned about the change in the market price of a security. The quarterly dividend will still be paid whether the market prices a stock at $40 or $50.
Focus on dividend raisers. The best income stocks to own during periods of rising rates are those with a solid history of regular and significant dividend increases. Companies that actually announce a target for dividend hikes are especially attractive. For example, Brookfield Infrastructure Limited Partnership (TSX: BIP.UN) aims for an annual distribution increase of between 5% and 9%. This year’s hike was even better, at 10%.
Emphasize short-term bonds. As I have said many times in the past, you should always keep some bonds in your portfolio. However, you’ll have to expect some capital loss in a rising interest rate environment. The shorter the term to maturity, the less the risk. And remember that all bonds held to maturity are redeemed at par value.
Take advantage of buying opportunities. The expected shakeout in interest-sensitive securities will open up some bargains. As share prices drop, yields will rise, assuming a company maintains or increases its payout. For example, BCE Inc. (TSX: BCE) shares closed on Aug. 21 at $54.65 to yield 4.95% on an annualized dividend of $2.60. If the share price should pull back to, say, $50, the yield on new purchases would be a more attractive 5.2%. And BCE is one of the companies with a record of regular dividend hikes.
The bottom line is that rate increases are coming, with the U.S. Fed move immminent. Be prepared for the changes this will bring and adjust your portfolio accordingly.
Courtesy Fundata Canada Inc. © 2015.Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder andThe Income Investor newsletters, available through his Building Wealth website. This article is not intended as personalized advice.
