Rising Interest Rates
Interest rates have risen significantly across the US Treasury yield curve YTD. This rise is the result of recent rate hikes by the US Federal Reserve and the increase in real (inflation adjusted) yields due to strong US economic growth. Bond investors rarely see calendar year losses. There have only been 3 in 40+ years for the US Aggregate Index. Additionally, as a result of a culmination of several factors including higher rates, tariffs, corporate profit growth concerns, the global equity markets have experienced a dramatic uptick in volatility and a corresponding fall in the major index averages.
What it Means
Rising real interest rates are generally indicative of a strong economy. After the Great Financial Crisis of 2007-8, real yields on bonds went negative due to the recession and Quantitative Easing provided by global central banks. As the Fed continues policy normalization while the economy has strengthened, especially after the Trump Tax Cuts, real yields are now positive and trending higher. Normalization implies a return of volatility in both stocks and bonds.
This volatility is evident from the recent market sell-off. The S&P 500, Dow Jones and tech heavy, NASDAQ are down 6.18%, 6.43% and 7.81% from their recent highs. Much of the decline has come in the last two trading days.
Equity investors are finally realizing the impact higher interest rates will have on economic growth. The Fed raises rates to attempt to keep inflation at bay before the economy overheats.
Portfolio Action
The purpose of diversified portfolios is to cushion equity drawdowns like this week. Investors with a diversified portfolio willingly trade some of the upside provided by the stock market so that they do not experience the inevitable drawdowns Rebalancing back to target allocations and lengthening the average maturity of client bond portfolios are the recommended actions steps. This includes reducing tactical fixed income exposure and increasing investment grade fixed income exposure.
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