Portfolio managers: Are you ready for a Fed rate hike?

The mid-December wording on interest rates from Chairman Janet Yellen and the U.S. Federal Reserve (the Fed) may have been a bit confusing, but if we look through the fog, one thing is pretty clear: The Fed is apt to raise U.S. interest rates by mid-2015. In our view, rates aren’t going to soar by any means, hitting perhaps 1% on the Fed Funds rate by the end of 2015. But, since any change in rates has an impact on all asset classes, portfolio managers will want to be thinking ahead about how rising rates might impact their clients’ investments.

The most obvious change will likely be in the fixed-income space. During 2014, despite strong U.S. economic trends, we saw rallies in longer-duration bond prices as investors sought safe assets due to a string of geopolitical and overseas economic scares.¹ Now, with Fed rates likely to go up, we see potential for shorter-duration bonds, as their prices are less sensitive to rising rates and are apt to offer better returns, though a flattening yield curve can be expected to offset some of the relative outperformance of shorter-duration bonds.

Portfolio managers may also want to look at floating-rate securities, such as bank loans.* These securities offer the advantage of “re-setting” as interest rates fluctuate and are higher in the capital structure than other assets with similar yields, such as high yield bonds. That gives bank loans the potential to offer better returns during a time of rising rates. But floating-rate bank loans also have risks, most notably that they have less liquidity, especially during periods of financial stress or fear.

Any Fed actions will also likely influence equities. Growth in U.S. equities has hummed along in the past year as the U.S. economy showed continued strength and investors desperate for returns piled in.²  However, Russell Investments is forecasting for 2015 that higher rates would likely reduce demand for securities based on infrastructure, utilities or REITS, as these sectors have been boosted by low interest rates and the ‘search for yield’.

Also watch for potentially higher volatility across asset classes. As we see it, both Former U.S. Fed Chairman Ben Bernanke and current Chairman Yellen have used the Fed to counterweight big swings in the market as they sought to impose financial order after the chaos of the market collapse six years ago. That counterweight is likely going to be less active going forward. So portfolio managers will need to be alert for potentially bigger market swings, and be ready to sell at the peaks or buy at the dips albeit at wider levels.

For more on this and other market forecasts, please see our recently released 2015 Global Outlook. It puts into perspective the actions of the Fed, other central banks, and outlines some of the hazards and opportunities for portfolio managers and investors. It’s well worth a look as we plan for the coming year.

¹ WSJ. "Treasury Investors Ready for Higher Rates”,January 1, 2015.

² WSJ: Money Beat Blog. “Wall Street Strategists Expect Stocks to Keep Climbing in 2015”, January 2, 2014.

*Bank loans can carry significant credit and call risk. In addition, they are difficult to value, have longer settlement times than other types of investments and are relatively illiquid.