Markets were jolted last week after learning that most members of the Federal Reserve Board believe economic conditions could be strong enough to warrant an interest rate hike in the near term. Previous comments by the Fed suggested that rates might stay stable for some time.
Quickly, the percentage implied by futures prices of a rate increase by the July meeting soared—from 4% to 45%. Meanwhile, bond yields shot up to their highest levels in months, pushing bond prices lower.
The Fed’s seeming about-face was driven by data showing relatively robust domestic economic conditions. For example, U.S. inflation in April rose at its fastest pace in more than three years, while unemployment has fallen to levels that economists have historically considered to be full employment. If second quarter GDP growth looks strong, the Fed may act in an effort to prevent the economy and inflation from overheating.
Only time will tell if the Fed boosts interest rates in the next two months. If it does, here are three key points for investors to keep in mind:
- A possibly stronger dollar. Historically, Fed interest rate hikes have pushed the U.S. dollar higher, and we’ve already seen the U.S dollar rise sharply during the past week. A sustained rally in the dollar may make U.S exports more expensive—and potentially cut into earnings of large domestic companies that generate significant sales from overseas markets. Currency-driven market volatility could occur in the coming weeks as investors attempt to interpret new data and the Fed’s reaction to it.
- Potential challenges for emerging markets and commodities. A rate-fueled stronger dollar may also push down the value of commodities (which are typically priced in dollars). That could create economic problems for emerging market nations that generate most of their revenues from selling commodities such as oil or precious metals. While falling oil prices could be a negative for commodity investors, it may lead to lower gas prices for consumers.
- Maintain a flexible fixed-income strategy.The Fed’s changing tone has created some confusion and uncertainty. In that environment, we believe the ability to interpret new developments and statements and to make dynamic portfolio adjustments in response to rapidly changing conditions could serve investors well. In the fixed-income portions of the Horizon portfolios, for example, we have recently taken steps to shorten duration (a move designed to protect capital when rates rise), eliminate exposure to foreign bonds (to help protect against a rising dollar) and increase exposure to corporate bonds that offer attractive yields.