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Why the Fed could raise rates TWICE this year: trader

Source: Flickr.com

By Kevin Mahn, CIO, Hennion & Walsh Asset Management

While I believe that the Federal Reserve would like to have adopted more of an increasingly hawkish stance—given solidifying economic data in the US and mounting inflationary pressures this year—it has instead taken more of a dovish tone, presumably to appease certain vocal dissenters and those concerned with global economic growth altogether.

However, prior to the release of new job market data on Friday morning, this “hovish” stance (a term I use to describe this hybrid state of hawkish/dovish positioning by the Fed) appeared to have been leaning more toward a hawkish stance, as Chair Yellen recently stated that she feels that the case for an increase in the federal funds rate has strengthened in recent months, while the Kansas City Fed President also recently suggested that it is time to move rates.

The market believes that we may only see one 25-basis-point (i.e. 0.25%) hike to the federal funds target rate (see chart below) and that it will be in December. However, I would not be surprised to first see an additional 25-basis-point hike in September (its next meeting that concludes on September 21).

From my perspective, this one (somewhat lackluster) jobs report should not, in and of itself, deter the Fed’s charted course given that the majority of their stated milestones have been reached. That being said, trying to accurately predict what this particular Federal Reserve is going to do next is often an exercise in futility.

United States federal funds rate target range (2006–2016)

Source: TradingEconomics.com, Federal Reserve

This does not, however, change my view that the Fed will likely embark upon a gradual and protracted period of tightening when they do ultimately commence upon a cycle of interest rate increases—similar to what occurred during the 2004 to 2006 time frame. At that time, the Fed raised the fed funds target rate 17 different times in 25 basis point increments.

The only difference during this round of tightening that we at Hennion & Walsh see is that the Fed may also consider starting to slowly shrink the size of its balance sheet, which is laden with Treasurys and government agency securities. That would be done over time in conjunction with increases to the federal funds target rate.

In other words, instead of just considering raising rates further after each FOMC meeting, it may consider some form of a gradual one-two punch of rate increases and sales of US Treasurys (or simply allowing maturing bonds to roll off their balance sheet).

What to buy during a rate hiking cycle

As a result, while this time around could certainly be different, I believe that investors would be wise to consider asset classes and sectors that have historically performed well during previous periods of gradual and protracted interest rate increases, such as the 2004-2006 period. For example, according to Bloomberg, the table below shows the cumulative total return performance of the 10 GICS sectors for the holding period 1/1/2004 through 12/31/2006.

GICS Sector Name Period Total Return %
Energy 114.63%
Utilities 75.69%
Telecommunication services 54.73%
Financials 40.72%
Materials 39.70%
Industrials 36.70%
Consumer staples 28.13%
Consumer discretionary 25.81%
Health care 16.39%
Information technology 12.28%

Source:  Bloomberg, March 2015. Cumulative total return data provided for the period 1/1/2004 – 12/31/2006. Past performance is not an indication of future results.

Please note: This information is provided for informational purposes only and is not a solicitation to buy or sell any of the asset classes or sectors discussed.