INSIDE THIS EDITION:
Inflation, Interest Rates, and Monetary Policy
Year-End Tax Planning and Financial Ideas
Weekly Snapshot of Global Asset Class Performance
401k Plan Manager *Updated on 10/23/2018
The accelerating pace interest rate increases in 2018 has certainly caused some painful experiences for bond investors.
The Federal Reserve has hiked the policy rate three times so far this year and is widely expected to bring the rate higher by another 0.25% in December. While interest rate risk has been in the news headlines since 2015, it did not materialize until 2018. Based on the Fed’s own projections, policymakers plan to further increase interest rates three times next year. This hawkish view has kept investors wondering, “are we entering a long-term bear market for bonds?”.
We believe that Fed is likely to slow down its pace of monetary policy normalization in 2019.
The U.S. Central Bank has two key objectives: maximizing employment and stabilizing prices. The first mandate has been achieved with the unemployment rate sitting at 3.7%. The Fed continues hiking rates because it worries that an overly tight labor market will eventually awaken inflation as wage pressure builds. Historically, an unexpected rise in inflation has forced the Fed to take an aggressive monetary policy stance and has often been blamed as the trigger for recession. However, recent economic data indicate that the historical link between employment and inflation has weakened significantly. Although the unemployment rate continues trending lower, the Consumer Price Index, Personal Consumption Expenditures, and most other measures of inflation have been drifting toward the Fed’s 2% target, after peaking in the summer. With declining oil prices and a softening housing market, there’s little evidence that the U.S. economy is in danger of overheating any time soon.
Market expectations of future inflation, as measured by breakeven points between nominal and TIPS Treasury Bonds, have also been cooling down.
The Fed generally aims to smooth the peaks and troughs of the business cycle by adjusting short-term interest rates. By lowering borrowing costs during a recession, the Fed stimulates consumer and business spending and helps manufacture an economic recovery. By increasing borrowing costs at business cycle peaks, the Fed puts a break on the economy to prevent overheating.
The Fed tends to be cautious raising interest rates when financial conditions are tight as the economy has a lower tolerance to increased borrowing costs. For example, the Fed only increased rates once in 2015 and 2016 when financial conditions were not favorable. When financial conditions became accommodative in 2017 and 2018, the Fed continued hiking rates (purple line in chart below). Since October, financial conditions in the U.S. have quickly tightened, following the sharp selloff in stocks and a moderate widening of credit spreads in the bond market. Tighter financial conditions help cool down the economy. So, the Fed shouldn’t be pressured to hike rates at a rapid pace.
Make no mistake, we don’t believe the rate hiking cycle is over. But it is our belief that the Fed is likely to slow down the pace of rate hikes and take a more patient approach to normalizing monetary policy. A dovish Fed supports bond prices and potentially weakens the U.S. dollar, which in turn benefits emerging market assets, commodities, and U.S. large cap stocks that derive meaningful revenues from international markets. A more gradual rise in interest rates would also help some key economic sectors, including housing and auto industries, whose customers’ purchase behaviors are sensitive to borrowing costs.
Weekly Global Asset Class Performance
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STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Written By: Scott Bishop, MBA, CPA/PFS, CFP®
The end of the year presents a unique opportunity to look at your overall personal financial planning situation. With factors like the 2018 tax law changes, life changes or just working towards your goals, now is an especially important time to review things. It is always a good time to see if you are on-track at your stage in life. Taking what we now know about the new tax law and weaving together all of the other areas of your personal finances is one of the key ways we provide value to you as your trusted adviser. Below are some things we’d like to help you think through before the year ends.
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