Predicting what the Fed will do in 2016 is likely to be easier than it has been in quite some time. Start with three hikes as a baseline, and then adjust the expectation up or down primarily based on labor market trends, putting the jobs data in the context of incoming inflation data. Then consider financial conditions, because the movement of stocks, bond yields and the value of the U.S. dollar can all influence the U.S. economic outlook and therefore the Fed’s decisions on interest rates.
For fixed income portfolios, our expectation that the Fed will move more than markets are priced for has a number of broad investment implications. That said, we believe that markets will be well-anchored over the medium term by expectations for global policy rates to stay below historical norms throughout the rest of the decade.
- In the near term, with markets underpriced for the Fed’s likely policy path, we suggest that investors consider keeping the duration of their fixed income portfolios shorter than normal to hedge against a rising rate climate. Focus in particular on underweighting duration on the shorter end of the yield curve, which will bear the brunt of Fed rate hikes.
- Second, in the context of our longer-term view on rates, we suggest keeping dry powder to take advantage of any market volatility that emerges in the rate normalization process, with an eye on adding to positions in credit instruments: non-agency mortgage-backed securities, corporate credit (both investment grade and high yield), bank capital and European peripherals.
- Finally, expect continued strength in the U.S. dollar owing to the divergence between monetary policies in the U.S. and abroad.
For more on the Fed outlook for 2016, please read the January Global Central Bank Focus.