Why You Shouldn’t Fear A Fed Rate Hike by Ashish Shah, AllianceBernstein

The Federal Reserve appears ready to raise interest rates next week. Bond investors fear that could pummel their portfolios. We’re not so sure—and we think moving to the sidelines now is a bad idea.

We understand investors’ anxiety. Tighter monetary policy causes most bond prices to fall, especially on Treasuries, investment-grade corporates and others with high interest-rate risk. A rate hike would also end an era of unprecedented monetary stimulus and signal a big change in the global financial environment.

But one 25 basis point (b.p.) increase won’t change everything overnight. While a rate hike would be the Fed’s first in nearly a decade, it would not be the first tightening of monetary conditions during that period. In fact, the Fed has already tightened policy considerably over the past 18 months.

How?

Mostly by ending its asset purchase program. According to calculations from the Atlanta Federal Reserve, the wind-down of quantitative easing tightened conditions by about 200 b.p. At the same time, central banks in Europe and Japan were loosening policy. That caused the US dollar to appreciate sharply, making financial conditions tighter still (Display).

Rate Hike

Market Is Ready for Interest Rate Liftoff

This stealth tightening made markets more volatile over the last year and amplified sell-offs in bonds, stocks, currencies and commodities. The US Treasury yield curve flattened (led by a sharp rise in two-year yields), high-yield bond spreads rose, and most currencies fell against the US dollar.

In other words, the sell-off that many investors fear will follow a Fed rate hike next week has already happened. On top of all this, one 25 b.p. rate hike isn’t much to worry about. Chances are the market will absorb it without much difficulty, not least because Fed officials have repeatedly warned investors in recent weeks that a rate hike is likely.

Don’t Panic; Instead, Be Watchful in 2016

In our view, investors who say they’re waiting to see what the Fed does before they invest may be making a mistake. Some of the assets that have struggled lately look attractive now—and may be poised for a rebound once the Fed gets that first rate hike out of the way. Bailing out of the market now or waiting to get in later may be costly.

Of course, the longer-term outlook is less certain. Continued Fed tightening throughout 2016 could have profound effects on assets around the globe, making bond investing more challenging.

This uncertainty is likely to keep markets volatile next year. That’s why it’s critical that investors conduct careful credit analysis and build a global, multi-sector approach into their portfolios.

But after the rough ride markets have had over the past year, one quarter-point rate hike is nothing to fear. For bond investors, we think there’s a good chance the holidays will be happy ones.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.