Interest-rate risk is elevated

Matthew F. Beaudry

Matthew F. Beaudry
Senior Investment Director, 05/02/18

  • With inflation becoming a greater concern than unemployment, the Fed is likely to continue raising interest rates
  • Although wage growth has been slow to materialize, the “quits rate” suggests that higher wages may be on the horizon
  • In a rising-rate environment, investors should consider investment allocations that mitigate interest-rate risk in fixed-income portfolios

Interest-rate risk is elevated Economic indicators and communications from the Federal Open Market Committee (FOMC) are both pointing to a high likelihood of higher interest rates in the near future. Considering the multi-decade period of falling rates since the 1980s — including the unprecedented zero-interest-rate policy in force from 2008 to 2014 — it is safe to say that we are in uncharted waters as we move toward an environment in which rising rates could possibly be the new norm. For investors allocating their fixed-income portfolios, that means it is time to consider investing opportunities outside of traditional benchmarks.

The Federal Reserve has communicated its willingness and intention to raise short-term interest rates in 2018 and 2019. The FOMC has a dual mandate of maximum employment and price stability. With unemployment at cycle lows and inflation ticking up, some economists are arguing that the Fed has met its objective and that it is time to “normalize” the interest-rate environment.

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What a “normalized” interest-rate environment looks like is up for some debate, but consider that many investors in today’s market have never made portfolio allocations during an extended period of rising interest rates. For example, the U.S. 10-year Treasury yield has declined from over 15% in the early 1980s to approximately 3% today. If history is any guide, we could be on the precipice of a multi-decade period of rising interest rates.

Faster wage growth could push up inflation

Such a rise would not be due exclusively to a reversion to the mean. Higher rates are also influenced by rising inflation, the result of stronger wage growth. If history is any indication, wage growth should continue to strengthen. In the past, when the unemployment rate has been as low as it is today, wage growth has increased by 3.5%–4% annually.

Currently, wage growth remains below 3%. Although it is climbing, wage growth has remained below its historical average for a number of reasons, including job automation, overseas outsourcing, the replacement of retiring baby boomers with lower-wage millennials, and the fact that some of the sectors offering the most jobs growth — retail, leisure/hospitality, and education — have average wages below the median.

Wage growth is trending higher as the labor market tightens

The quits rate offers clues

The Job Openings and Labor Turnover Survey (JOLTS) provides monthly data on the number of workers voluntarily leaving their jobs. Most economists consider this quits rate a good indicator for wage pressure and inflation, as workers quitting their jobs usually only do so for better opportunities and higher pay. Today, there is a high level of confidence among job switchers, and historically, the quits rate leads wage growth by about six months.

A rising quits rate historically is a precursor to wage growth

With wage pressure and inflation moving upward, the Fed signaling its intention to raise short-term interest rates, and the approaching end of an unprecedented era of falling interest rates, indications point toward higher rates ahead. How will this impact fixed-income portfolios? To quantify the potential loss for fixed-income portfolios from rising rates, the chart below shows the price sensitivity from a 100-basis-point move (1% move) in rates for various bond maturities. For example, in today’s interest-rate environment, a 100-basis-point rate rise would equate to a nearly 9% loss in the 10-year bond.

Potential losses from rising rates for various bond maturities

Rising rates are not inherently bad for investors. However, as indicated by the chart above, relatively small increases in interest rates can drastically dampen the worth of interest-rate-sensitive fixed-income products. For that reason, it is essential for those investors with traditional fixed-income portfolios to seek out strategies that reduce their exposure to interest-rate risk.