More Evidence Central Banks Will Hike Rates

Financial advisors wondering which way the wind blows on interest rates received some guidance recently, in the form of Federal Reserve comments and softer inflation data.

That guidance may be pointing them to a more aggressive investment stance going forward.

“Central banks increasingly are moving away from excessively easy monetary policy,” said Richard Turnill, global chief investment strategist at London-based Blackrock. “Yields paused after recent gains, partly on soft inflation data. Yet we see them rising gradually, reinforcing the case for stocks over bonds.

The Federal Reserve appears committed to normalizing interest rates further and initiating its balance sheet reduction this year, Turnill added in a new research note.

“Fed Chair Janet Yellen appeared to reinforce this stance … in Congressional testimony that we view as consistent with past communications,” he said. “Also, the Bank of Canada raised rates for the first time since 2010 and markets expect an October rate hike.”

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Stocks “rallied” after Yellen’s Congressional testimony, mostly led by emerging markets, Turnill said.

Economic experts see the Fed adding to its recent list of rate hikes (the Fed has hiked rates three times in the past seven months.)

“Analysts surveyed by FactSet are predicting one more rate hike this year, in the second quarter, while futures prices indicate a less than 50 percent chance of one or more hikes this year according to CME calculations,” said Sara Potter, vice president of markets analysis at FactSet.

'Dual Mandate'

The Fed has a dual mandate to “foster economic conditions that achieve both stable prices and maximum sustainable employment,” Potter said. “The headline unemployment rate is at a 10-year low of 4.4 percent but, despite anecdotal evidence of tight labor markets, we are not seeing the expected surge in wages that would normally accompany such a low jobless rate.”

Inflation isn’t a big factor right now, which could well curb the need for future hikes.

“Although consumers would like higher wage growth, they are benefiting from continued benign inflation numbers,” Potter said. “Following the largely commodity fueled jump in prices in January, both monthly CPI and PCE price indices have remained essentially flat in recent months. On a year-over-year basis, we are seeing steady declines in the growth rates for both measures, including their core counterparts.”

Unless those numbers change, the odds of a third rate hike in 2017 are narrowing, she noted.

The Fed also seems to be threading a needle with its current interest rate strategy, one that should benefit stocks, if even for unique reasons.

“With its recent rate changes, the Fed has focused on telegraphing each impending change so explicitly that by the time it is announced, the change has already been fully accounted for in the markets,” Potter said. “Normally a rate hike hurts equity markets, since it makes it more expensive for companies to do business because they have to borrow money at higher rates, and they are valued lower.”

However, if market players perceive that a rate hike will help to keep the economy growing steadily without overheating, it may have a positive impact, she added.

Other Wall Street insiders agree that the Federal Reserve may have at least one more rate hike planned for 2017 – but no more.

“Market consensus states there is a 52 percent probability that the Fed will announce a 25-basis-point interest rate hike,” said Bob Johnson, president and CEO of The American College of Financial Services, in Bryn Mawr, Pa.

Low Inflation Rate

The CME Group publishes a FedWatch tool that determines the current probability of rate hikes by tracking Fed fund futures prices, Johnson said. The FedWatch tool indicates an 8 percent chance of a hike by September and a 10 percent chance by November, he said.

Like Potter, Johnson points to that “dual mandate” - maximizing employment and stabilizing prices.

The current U.S. inflation rate for the 12 months ended June 2017, as published by the Department of Labor, is 1.6 percent, while the Fed's target inflation rate is 2 percent.

“The Fed's hesitancy to raise rates is because of uncertainty about when and how inflation will respond to tightening resource allocation,” Johnson added. “The Fed doesn't want to raise rates prematurely and forestall economic growth.”

As long as inflation remains under 2 percent, the Fed will maintain rates at the current level, and that’s good news for stock investors.

“The biggest factor driving the stock market rally is low interest rates,” Johnson said. “Warren Buffett is in that camp. In an interview with Yahoo Finance’s Andy Sewer this April, Warren Buffett was quoted as saying ‘Everything in valuation gets back to interest rates.’”

Following the Berkshire Hathaway annual meeting, he told CNBC’s Becky Quick “that if these rates were guaranteed to stay low for 10, 15 or 20 years, then the stock market is dirt cheap now.”

As rates rise, bonds become more attractive to investors relative to stocks – and that’s a scenario where money managers can take advantage in the second half of 2017.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at brian.oconnell@innfeedback.com.

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