In the Know: Fed Lifts Rates, but “Lower for Longer” Likely

The markets can finally put the US interest-rate debate to bed (at least for the time being) as the Federal Reserve lifted its benchmark short-term lending rate for the first time in a year. While it appears that further US rate hikes are likely ahead, Franklin Templeton Fixed Income Group’s Chris Molumphy believes the “lower-for-longer” interest-rate environment is likely to persist. He also cautions against some of the market exuberance that has been following the US presidential election.

Q: What’s your perspective on the Federal Reserve’s (Fed’s) decision to raise short-term interest rates?

A: Overall, we think the Fed’s move was a healthy course, given the unusually low level the federal funds rate has been at for a long period of time. The increase was long anticipated and fully priced into the market, so we think it’s more important to look at the Fed’s guidance in terms of where rates might be going in 2017 and beyond.

The federal funds rate remains extremely low (even after this increase), and we would anticipate that short- and even long-term interest rates are likely to remain quite low going forward. As we look into 2017, we are likely to see the federal funds rate averaging somewhere around 1%, which is still extremely low. While we would anticipate there to be more interest-rate increases ahead, we’d expect them to be gradual. Remember, it was December 2015 when the Fed raised rates for the first time in this cycle, so we’ve seen a full 12 months between increases. We expect the time frame for the next rate hike to likely contract going forward, but we see the pace of increases being extremely gradual, something on the order of 0.75% per year for the next couple of years. While interest rates are rising, we think the nominal rates and pace of future increases need to be kept in mind.

Q: What are the implications of rising rates for fixed income investors?

A: First, we have to be careful to differentiate between short- and long-term rates. We’d anticipate the Fed to continue to raise short-term rates in 2017 and beyond, but long-term rates move in anticipation of Fed actions, and we have already seen a pretty significant move higher. Thus we wouldn’t necessarily see a significant additional rise in longer-term rates.

In terms of different types of asset classes within the fixed income space, it’s difficult to generalize because different asset classes are driven by different factors and have different interest-rate sensitivities. For example, leveraged bank loans, which are floating rate in nature and very low-duration assets, could do well in a rising short-term interest-rate environment as they continue to adjust with rising rates.