Neil Shankar explains what advisors should take from the first US interest rate increase in three years
Looking at the bond market this week could give some investors cause for alarm. 10-year US treasury bond yields have exceeded five per cent for the first time since 2008 as markets priced in the likelihood that the US Federal Reserve would hike interest rates. That hike came yesterday as Federal Reserve Chair Kevin Warsh told markets that a 25 basis point increase in interest rates would expedite the US economy’s move towards the Fed’s two per cent inflation target and remove a “dose of accommodation” from monetary policy.
While in the immediate aftermath bond yields remained high, albeit appearing more stable, and equity markets sold off Neil Shankar doesn’t believe we see a significant hiking cycle now underway. Shankar is Vice President of Economic Research at CI Global Asset Management. He explained the decision to hike more as a “recalibration” than the start of a full-blown hiking cycle. He noted how the Fed under Warsh seems more willing to leave markets without forward guidance and explained what advisors need to tell their clients in the wake of this move.
“And if we take a look at some of the recent data, the economy and labour market have generally held up, which ultimately provided the Fed with some room to remove some of the insurance easing it delivered last year. Rather than signalling a return to the kind of tightening campaign that we saw in 2022,” Shankar says. “To me, the bigger message was not that rates are headed substantially higher, but that the Fed wants to ensure inflation returns to target more quickly, and it’s not willing to take any of the progress that we’ve seen for granted.”
Markets moving without Fed guidance
At various points in his press conference following the announcement, governor Warsh emphasized that he does not like to provide forward guidance. Moreover he described the idea of a neutral rate more as an intellectual exercise than a meaningful or substantive target for the Fed. Shankar accepts that this style of communication makes it harder to understand the Fed’s medium-term policy reaction function.
Despite some speculation that the Fed raised rates to reverse the rise in bond yields we’ve seen in recent days and weeks, those bond yields did not fall in the wake of the decision. While certain durations stabilized, Shankar still sees wider risks to the US and global economies stemming from high borrowing costs in the United States. He notes that Fed policy is only one factor in those high rates, however, which appear to be driven by significant levels of fiscal debt in the US and much of the developed world, as well as significant private sector debt issuances, largely connected to AI capital expenditures. There is a chance, though Shankar believes we’re not there yet, that the slowdown in economic activity proves more significant than the Fed intends.
US economic resilience, supply-side inflation
At the moment, however, Shankar says that the US economy is still quite resilient and that relatively strong GDP growth and hiring should support the economy through some interest rate increases. Growth is relatively narrowly driven, however, largely coming down to US consumers and the ongoing AI buildout.
The inflation that Warsh and the Fed want to tame, it should be noted, is largely supply driven. High energy prices tied to conflict in the middle east sit at the core of US inflation, and monetary policy can do little to curtail that. “Higher interest rates don’t, produce more oil, or build more semiconductors, or lower tariffs,” Shankar says.
Warsh, when asked about this during his press conference, said that the Fed hopes higher rates will prevent that supply-side inflation from spreading into the wider economy. Shankar says that if we see high energy prices driving demands for higher wages or increasing inflation expectations, then we are seeing that contagion. He says that monetary policy has only a limited impact on this supply-driven inflation.
Where this leaves investors, advisors
Despite some stabilization on bond markets, Shankar notes that the risk remains that long-term yields will continue to rise. The broader forces of high fiscal deficits and significant corporate bond issuances to finance capital expenditure remain in place, leaving bond investors with the risk of higher yields. Shankar argues, however, that we are not approaching a “Liz Truss moment” for the United States.
For Canadian investors looking at the bond market, Shankar says there is some upside as bonds now pay even more attractive yields. In past regimes of low interest rates, the only way to generate return was for yields to fall. Now, he says, investors can be happy to clip coupons on 5 per cent yields. That reality offers new opportunities for advisors in terms of portfolio construction as well.
As they look at the risks and opportunities in bonds, Shankar says that advisors should continue to reinforce stability and caution, driving home the point that despite some volatility we are not looking down the barrel of another bear market in stocks and bonds like we had in 2022.
“It’s a single Fed decision. I think a lot of investors may still be scarred by what happened in 2022, but one rate hike does not mean that we’re heading back to that an aggressive tightening cycle that we saw in 2022,” Shankar says. “To me at least, it looks more like a recalibration of monetary policy than an aggressive tightening cycle. And you know the other thing I’d reiterate is that the economy and labour market have held up, which have essentially given the room for the Fed to remove a dose of last year’s insurance easing. And that’s very different from 2022 when the Fed was trying to catch up with a broad and deeply entrenched inflation problem.”
