Interest Rates Market Impact and Our Portfolio
September 27th, 2022
This week, stocks and bonds were down after the Federal Reserve again raised interest rates by 0.75%. Commentary from Fed chair Jerome Powell reinforced the idea that the Fed is committed to fighting inflation until we see significantly lower levels closer to the Fed’s 2% target (some way from the August inflation print of 8.3%).
While the interest rate increase was widely expected, Powell’s commentary caught some investors by surprise. As a result, the market is now expecting a higher terminal (peak) federal funds rate. While the Fed’s actions and commentary around interest rate increases have brought short term pain in stocks and bonds this week, we believe they are a step in the right direction towards bringing inflation under control. Our view is that the earlier inflation is under control, the better for the economy, debt markets, and equity markets over the long term.
Impact of higher interest rates on US treasuries
Higher expected interest rates have had a negative impact on US treasuries, with the 10-year yield spiking from 2.5% in August to 3.7% today. As we know, when bond yields rise, bond prices fall. Over the last month, the Vanguard long term bond fund BLV (purple line) has fallen in value by 6% - a large fall for an investment with a low expected return. Medium term US treasuries have fallen too, as measured by Vanguards VFISX (orange line), though by a lot less. This shows that in a rising interest rate environment investors are better positioned in short-medium term treasuries rather than long term treasuries.
1 month returns – medium and long term US treasuries
How our fixed income portfolio is positioned
We have low exposure to long term US treasuries – the bulk of our exposure is short and intermediate term.
Structured yield notes within our enhanced fixed income portfolio are priced mainly on underlying reference assets. The fundamental value of these yield notes moves more based on these underlying reference assets opposed to changes in interest rates (which have gone up significantly over the last week).
Our corporate bond exposure is mostly floating rate, which allows investors to benefit from rising interest rates since the rate is adjusted periodically to current rates on the market.
Key takeaway
Interest rate increases have been negative for stock and bond prices over the last month (especially long term bonds). However, we have held the position that the Fed has no choice but to act firmly with interest rate rises in order to tame inflation. As a result, while their interest rate increases have brought short term pain, they are a step in the right direction towards bringing inflation under control.
The earlier inflation is under control, the better for both debt and equity markets over the long term in our view. We continue to maintain balanced portfolios with defensive posturing and hedges in place. We have confidence in our investments in high quality American companies that can grow their earnings over the long term. While market pullbacks are mentally and emotionally challenging, history shows that recoveries are almost always stronger.
Disclaimer
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