Plans are Nothing. Planning is Everything.

U.S. investors are largely convinced that the Fed will raise interest rates in the middle of 2015 but sluggish inflation could push that eventuality back into 2016.

by Scott Minerd, CIO, Guggenheim Partners LLC

Federal Reserve Chairwoman Janet Yellen made quite an impression at her inaugural press conference when she indicated that interest rates could begin to rise no sooner than six months after the Fed’s asset purchases end. But, perhaps of greater interest were her statements making clear that U.S. inflation has replaced unemployment as the primary factor she will consider when choosing the specific timing of the first increase in interest rates. Now, financial markets are getting more sensitive to inflation expectations and announcements. While investors will likely debate ad nauseam the level of inflation which will compel the Fed to act, the timing of hiking the federal funds target rate will depend largely on the balance of power between Fed hawks and doves. The hawks believe policy must stay ahead of inflation for fear of losing control and having to raise rates even higher, while the doves are unlikely to act until they can see the whites of inflation’s eyes. In reality, the slow progress toward the Fed’s 2 percent inflation target could see the whole debate being deferred late into 2015 or even the beginning of 2016. History, as shown in the chart below, suggests that equities should outperform fixed-income assets in the year leading up to the eventual rise in interest rates.

The Fed’s “dots” chart anonymously plots where Fed officials believe short-term rates will be over a three to four year horizon. Today, the majority of dots predict a longer-run federal funds target rate of 4 percent or above, with some dots reaching 4.5 percent. Historically, as the Fed raises rates, the Treasury yield curve becomes flatter, and in time, the 10-year U.S. Treasury yield drops below the fed funds rate. So, if the “dots” are correct, and the fed funds rate is headed to as high as 4.5 percent, it is possible that the 10-year U.S. Treasury note will reach 4-4.25 percent.

This means that floating-rate assets, particularly bank loans and collateralized loan obligations, will likely continue to outperform. Flows into bank loans should continue as interest rates rise and there is likely some spread tightening left in the sector. The bad news is that securities in the three to seven year area, called the belly of the curve, will likely underperform. Credit spreads should not start to widen until we see an increase in defaults, which start to tick up usually about one to two years after the Fed begins to tighten. So, even if you believe Dr. Janet Yellen will begin raising interest rates in 2015, credit spreads are unlikely to meaningfully widen until late in 2016 or 2017.

Chart of the Week

U.S. Equities Outperform in 12 Months Before Fed Tightens

Federal Reserve Chairwoman Janet Yellen has made it clear that she could raise interest rates as early as June 2015, although we do not see that as likely. During the 12 months before a Fed tightening cycle begins -- a period we could now be entering -- U.S. equities have typically outperformed fixed income by a wide margin. In the last five periods leading up to Fed tightening, the S&P 500 has gained 22 percent on average in the year before the Fed began raising rates, compared to 4.2 percent or less for fixed-income assets.

PRICE PERFORMANCE DURING THE YEAR BEFORE FED TIGHTENING*

Source: Credit Suisse, Barclays, Bloomberg, Guggenheim Investments. Data as of 3/31/2014. *Note: Average price performance in the 12 months prior to Fed tightening cycles in 1983, 1986, 1994, 1999, and 2004.

Economic Data Releases

U.S. Data Emerging from Winter Slowdown

• The ISM manufacturing index rose in March to 53.7, rebounding from the winter slowdown. The index indicated that production surged while gains in employment slowed.
• University of Michigan consumer confidence was revised slightly higher in the final March release, but remains at the lowest levels since November.
• The ADP Employment Report showed 191,400 jobs added in March, slightly below expectations for Friday’s non-farm payroll release.
• Pending home sales unexpectedly fell by 0.8 percent in February. Sales have now dropped for eight straight months.
• Personal income rose 0.3 percent in February, in line with estimates.
• Personal consumption expenditures grew 0.3 percent in February, the 10th straight monthly increase.
• The core PCE price deflator was largely flat in February at 1.1 percent year-over-year.
• Unemployment claims fell to 311,000 from 321,000 for the week ended March 21st, the lowest level this year.
• Construction spending increased 0.1 percent in February after a 0.2 percent February decline. Non-residential building was responsible for the increase.
• U.S. factory orders increased 1.6 percent in February after falling the previous two months.

Euro Zone Prices Head Lower, Abenomics Momentum Slows

• Euro zone economic confidence increased for an 11th straight month in March, reaching the highest level since July 2011.
• The euro zone wide CPI ticked lower in March to 0.5 percent in the preliminary release, the lowest since October 2009.
• The euro zone producer price index fell in February, reaching -1.7 percent year-over-year, more than four-year low.
• Retail sales in Germany were strong in February, rising for a second straight month at 1.3 percent.
• Germany’s unemployment rate reached a record low of 6.7 percent in March as unemployment decreased by 12,000 people.
• The U.K. manufacturing PMI continued cooling in March, falling for a fourth consecutive month to 55.3.
• U.K. retail sales jumped more than expected in February, up 1.7 percent, driven by strong food sales.
• China’s official manufacturing PMI ticked up to 50.3 in March from 50.2. The report was partly offset by a small downward revision to the HSBC manufacturing PMI, which decreased to 48.0.
• Japan’s Tankan Survey of large manufacturers rose less than expected in the first quarter, inching up to 17 from 16. The outlook for manufacturers and non-manufacturers dropped after increasing the previous four quarters.
• Japan’s CPI ticked up in February to 1.5 percent from 1.4 percent, while core CPI was flat at 1.3 percent.
• Japanese industrial production was worse than expected in February, dropping 2.3 percent, the largest monthly decrease in eight months.

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