Yesterday, the Federal Reserve signaled a pause in its increases to the benchmark interest rate. This is not entirely unexpected, as the Fed had been periodically hiking or pausing for the last three years. This time, however, Fed Chairman Jerome Powell indicated a likely longer hold.
This development falls in line with our assessment of the current economic environment. The Fed likely wants to raise rates farther in order to normalize policy and create cutting room for the next recession, but can no longer justify those hikes. Despite historically low unemployment, inflation remains below the Fed’s 2% target; China and Europe are both seeing dramatic slowdowns in economic growth, which, in this global 21st century environment, will also affect the U.S. economy; and the month-long shut down tripped up some forecasts for U.S. growth this year. Raising rates insistently in this situation would be actively pushing the economy into recession, somewhat similar to what happened in 2006.
From 2004 to mid-2006, the Federal Reserve raised rates from 1% to 5.25%, voting for a hike at nearly every meeting. Despite warning signs from the bond and housing markets, the hikes continued. Shortly thereafter, the Fed had to slash their Fed Funds interest rate as the economy tanked into what is now known as “The Great Recession.”
This somewhat precipitous rise and fall seems to be what Chairman Powell is attempting to avoid with his pause. Instead of dragging the economy up, up, up, to the top of a cliff and falling right off, Powell seeks to spend some time on a happy hillside where everyone may enjoy some stability for a time.
This is good news for our CMO strategy. With interest rates up and expected to hold steady for a time, we should see more availability in the discount CMO market. At the same time, by not raising borrowing costs too high, Powell is helping to keep the housing market strong. Strong real estate means faster prepayment speeds on our bonds, which leads to a more dynamic portfolio. Inverse bonds in our portfolios will also maintain higher coupons at this level than if the rate hikes continued.
By pausing now, Powell and the other Fed chairs are giving the economy a chance to catch its breath. There is no need to push interest rates higher in the current environment, and we are glad the Fed recognized that this time around. We look forward to what 2019 will bring.
This information is not intended to be used as the only basis for investment decisions, nor should it be construed as advice designed to meet your particular needs. You are advised to seek the advice of your financial adviser, legal or tax professional, prior to making any investment decision based on any specific information contained herein.
