The Federal Reserve increased their key interest rate when they met in June. Let’s review why they made the change and how this rate increase affects our fixed income strategies.

What is the Federal Funds Rate?

The Federal Funds Rate is the interest rate at which banks and credit unions lend reserve balances to each other on an overnight basis. This rate is one tool by which the Federal Reserve (the Fed) implements monetary policy by setting a target or range for the rate. A change in the Federal Funds Rate can have a broad impact on the economy as it tends to influence other short-term rates that determine consumer borrowing costs, such as credit card and auto loan rates. When the Fed wants to tighten credit to control inflation, it raises the target rate. When the Fed wants to ease credit to stimulate economic activity, it lowers the target rate.

What was the outcome of the Federal Open Market Committee’s June meeting?

In line with nearly unanimous market consensus, the Federal Open Market Committee (the Committee) raised their target range for the Federal Funds Rate by a quarter of a percentage point to 1.75 – 2.00%. The Committee’s decision was based on a labor market that has continued to strengthen and economic activity that has been rising at a solid rate. This is the second rate increase in 2018, and the Committee views its monetary policy as remaining accommodative to economic growth.

The June meeting did produce some modest changes in the Fed’s economic view and interest rate outlook. In its press release, the Fed modestly strengthened its language describing the rate of economic activity and growth in household spending. In addition, Fed officials also upgraded their forecast from three to four total rate increases in 2018, as unemployment falls and inflation is expected to approach its 2% target rate faster than previously projected.

How does this rate increase affect our fixed income strategies?

The immediate price effect on our fixed income strategies should, in our opinion, be modest for two reasons:

  1. This rate increase had been widely anticipated for some time, so it was already priced into the market.
  2. Our fixed income strategies invest in short-term bonds, which are less sensitive to a given change in interest rates. This also means that any future rate increases would have less of a price impact compared to strategies invested in longer-term bonds, assuming rates increase by the same amount across bond maturities.

The near-term reinvestment effect on the our fixed income strategies should, we believe, be favorable. In fact, we should expect to see higher income from these strategies going forward because they invest in short-term bonds, which mature more quickly. If the Fed continues to raise rates according to current projections, proceeds from the maturing bonds would likely be reinvested in higher-yielding securities more quickly.

Bryan Karcher, CFA, CAIA, CIMA
Fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall, and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Fixed-income securities sold or redeemed prior to maturity may be subject to loss.