Markets Believe Interest Rates Are Headed Up

US News

The long bull market still has some life left in it, but investment markets are beginning to return to the kinds of normal conditions that existed prior to the Great Recession, according to investment experts who spoke at Bank of America Merrill Lynch Global Research's midyear economics and market review Wednesday.

Michael Hartnett, Merrill Lynch's chief investment strategist, said the firm's overall outlook is being driven by two core convictions. The first is that the global and U.S. economies will continue to experience slow growth and lots of liquidity, owing to slack demand and continued accommodative monetary policies from the Federal Reserve and other central banks.

The second conviction is what he called the "great rotation theory," which is fancy language for a return to the kinds of market conditions that existed several years ago. The "new normal," Hartnett said, is "back to the old normal." The recovery of the U.S. housing market is a key lead indicator, he explained, that brings a return to more normal capital flows and interest-rate patterns and a retreat from investors' insistence on avoiding market risks - long after doing so began producing unjustifiably low returns.

[Read: 7 Ways to Turn $250,000 Into Retirement Income.]

In terms of interest rates, Priya Misra, head of U.S. rates strategy for Merrill Lynch, said investors should expect rates to rise over time, but calling near-term movements is very hard. The Federal Reserve has been emphasizing it will not back away from its extended policy to ease rates until the nation's stubbornly high jobless rates have dropped to historically acceptable levels.

However, Misra said the markets have been behaving as though they don't believe the Fed. The conflict between stated Fed policy and market behavior is creating volatility in short-term movements of rates. The market believes the Fed is already tapering off its quantitative easing program.

Merrill Lynch is forecasting higher rates at the end of this year and into 2014. Further, based on models used by the firm, Misra said the market is behaving as if the Fed will raise interest rates before the end of 2014. However, we're still talking about very low rates in the 2 to 3 percent territory.

Over time, rising interest rates will improve the yields that retirees receive on bonds, certificates of deposit and other traditional fixed-income investments. This will be part of the return to normal. However, the increase in rates could be costly to investment portfolios with large percentages held in bonds. Bond prices fall when interest rates increase, and rates have been so low that even a small rise can have a big impact on prices.

Target-date funds and other retirement portfolios traditionally place a lot of investor funds in bonds, both to generate interest income and because bonds have been considered safer and less volatile than stocks. Today, however, bonds may be more volatile and thus even less safe.

[Read: Will Your Target-Date Fund Retire Before You Do?]

Savita Subramanian, Merrill's head of U.S. equity and quantitative strategy, said investors now are engaging in a "fundamental mispricing of risk." The demand for safe returns has driven them into dividend stocks and other holdings to such an extent that holdings in these so-called low "beta" (or volatility) investments caused them to ignore better and even safer returns in higher-volatility investments. In terms of relative returns, she said, investors are actually losing money in high-dividend yield portfolios.

Subramanian said Merrill feels investment markets are at an inflection point for a dramatic reversal. Increasingly, she predicted, investors will favor corporate earnings and growth over safety and low volatility. This will drive a shift out of relatively high-yielding holdings and into more traditional growth stocks. And while holdings will continue to be favored in big companies, such as those in the S&P index of 500 large firms, there will be a shift in preference away from U.S. firms to multinational companies.

[See: Are the Fund Industry's Top Stock Pickers Beating the Market?]

In terms of the U.S. economy, Ethan Harris, co-head of global economics research, said it's "way too early to declare victory" in terms of continued recovery, and "the federal government is in a full-blown recession" due to the sequestration-related spending cuts.

But he said slow growth should begin giving way to better numbers later this year and then to gross domestic product increases running ahead of 3 percent in 2014. There is little sign of inflation becoming a problem, he added.



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