With 400 basis points of Fed Funds rate increases over the past 24 months, investors are rightfully anxious about the impact of the Fed tightening policy.
Our study finds that historically falling core CPI data tends to encourage the Fed to stop raising rates. Other key indicators, however, do not seem to have strong predictive power.
The yield curve tends to have powerful rallies when the market perceives an upcoming interest rate cut. We believe investors should consider the Fed’s potential easing moves in making portfolio extension decisions.
While the decision to extend portfolio maturities ahead of a definitive Fed statement is always a complicated one, the potential benefit of locking in higher yields may justify such a move.
In May 2005, we published an article titled “As the Fed Moves from Predictable to Data Dependant: Is the End Near?” In the study, we examined historical data from the last five interest rate tightening cycles since 1977 in order to put current conditions into perspective. At the time of the study, the Federal Reserve had raised interest rates eight times for a total of 200 basis points. Oil futures were hovering around $50 a barrel, and the market buzz was that the Fed might soon drop the “measured” language.
Fast forward 13 months, and the Fed has raised the target rate by another 200 basis points. Crude oil futures are now hovering around $70 a barrel. A new Fed chairman is in the driver’s seat and the housing market is cooling. Economic growth is expected to be tepid for the rest of the year; however, core inflationary pressures are building. Throw in the threat of an avian flu pandemic and a nuclear conflict with Iran, and what is the Fed’s position on future interest rates under these circumstances? Data dependant!
As fixed income investors, we are thrilled to see short-term securities yielding above 5% for the first time in five years. Meanwhile, we are equally aware of the risk of locking in today’s levels if the Fed continues to raise rates substantially higher. In keeping with our tradition of reviewing today’s interest rate environment within a historical context, we set out to observe the time period from three months prior to the Fed’s adoption of a neutral monetary policy stance to the beginning of the next easing cycle.
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