This site uses cookies.  By continuing to browse this site you are agreeing to our use of cookies.   Find out more.

The Ripple Effect of Rising Rates

January 2014

BNY Mellon Wealth Management

The Federal Reserve's plan to curtail its massive asset purchase program has triggered heightened market volatility. Higher long-term interest rates, and the prospect of further rate rises down the road, have resulted in ongoing outflows from bonds. Some investors have shifted their assets toward cash alternatives, accepting near-zero yields in exchange for perceived safety. While stocks have been on an upward trajectory since the recession, uncertainty over whether the economy can sustain the equity bull market has kept many investors from participating in the ascent.

The outlook for the economy and interest rates has significant implications not just for fixed income, but for other assets within the highly interwoven global economy. Even though the Fed is likely to keep short-term rates low for some time, investors may want to reevaluate their asset allocation and investment strategies, and how they can position themselves to meet their goals for income, growth and capital preservation in a normalized rate environment.

U.S. Economy: Transitioning to Somewhat Faster Growth

It's important to remember that the Fed's intent to gradually withdraw its extraordinary monetary stimulus is being driven by something fundamentally positive: A U.S. economy that appears to be gaining strength. We believe the U.S. may be near an inflection point toward a somewhat faster growth rate as the fiscal drags that weighed on the recovery have waned. We expect the pace of U.S. expansion to accelerate to about 3% for the next three years beginning in 2014 — above the 2% trend that marked the past four years.

This does not mean that the Fed is likely to raise short-term interest rates any time soon. While the labor market has shown improvement, unemployment is still above the 6.5% rate that the Fed views as a threshold for ending accommodative policy. Further, inflation appears to be a distant threat, with the Consumer Price Index (CPI) running comfortably below the 2.5% pace that can cause the Fed to become restrictive. As outlined in Exhibit 1, short-term rates have been anchored well below core inflation for some time.

Exhibit 1 // Short-term Rates Anchored Well below Core Inflation

Effective Fed Funds Rate Less Core CPI

Figure 1 //  Short-term Rates Anchored Well below Core Inflation

As of 9/30/13. Sources: Federal Reserve, U.S. Department of Labor and FactSet

We do not believe that the U.S. economy is very inflation prone, since there is an excess supply of labor and foreign competition remains intense. Disinflationary forces, such as a recently strengthening U.S. dollar and flat to declining commodity prices, have also been at work. As a result, we expect the Fed to keep short-term rates anchored near zero until mid-2015, at which time we expect a gradual rise of about 50 basis points per year. Also, as evidenced by recent yield curve steepening, the severe mispricing in intermediateand long-term yields has been corrected. We believe investors may want to prepare for a normalized cyclical pattern in which short-term interest rates gradually drift higher and the yield curve flattens.

Implications for Fixed Income

An Active Approach Can Identify Opportunities

Investors no doubt have felt the pain of normalizing rates, with performance challenges across most fixed income sectors. In this environment, it makes sense for investors to re-examine their fixed income holdings. Yet it remains important for most investors to keep a strategic allocation to bonds — one that is diversified across sectors and managed for interest rate risk.

For active bond managers, the shifting economic landscape will not only produce new risks but new opportunities as well. In fact, the transition to normalized rates will likely produce dislocations which experienced managers can capitalize on. For example, several years ago, California municipal debt experienced pricing pressure as a result of state budget woes. Savvy investment managers were able to identify undervalued securities that have since performed well.

A stronger economy should also have longer-term benefits for fixed income. Default rates are likely to fall and higher interest rates will allow for reinvestment at higher yields. This can ultimately benefit portfolio returns. In this environment, an active manager can strive to enhance total return potential through strategic use of duration, coupon and maturity management.

Planning for Yield Curve Shifts

Although the yield curve is currently steepening, eventually it will flatten as the Fed begins to raise interest rates. While it remains steep, it may be beneficial for investors to overweight short- to intermediate-maturity bonds. To mitigate interest rate risk, we believe it is better to allow a fixed income portfolio to drift toward a shorter duration (through the maturation of holdings) than to aggressively tilt it toward shorter-term securities. This may also help avoid an unnecessary sacrifice in income over coming quarters while short-term interest rates are expected to remain low.

We caution investors against an over-allocation to short-term securities given the likelihood that the yield curve will flatten as the Fed eventually raises rates. As outlined in Exhibit 2, two-year Treasury yields rose the most during the past three tightening cycles. The chart measures the increase from the onset of tightening to the point that the Fed Funds rate reached its peak.

Exhibit 2 // Shorter-term Treasuries Have Risen the Most in Past Fed Tightening Cycles

Figure 2 // Shorter-term Treasuries Have Risen the Most in Past Fed Tightening Cycles

Source: Bloomberg

Diversification through Core and Satellite Strategies

At BNY Mellon Wealth Management, we believe in a diversified fixed income approach that combines core fixed income holdings with more targeted satellite strategies. Core strategies typically include U.S. dollar-denominated, investment grade municipal, corporate and government securities. Satellite strategies include high yield, emerging markets debt, undervalued municipal securities and higheryielding corporate bonds. The additional yield on many satellite strategies can complement a core allocation by increasing portfolio income and helping to cushion the negative impact of rising rates. In addition, more flexible satellite strategies such as floating rate loans are less vulnerable to interest rate risk since their coupon payments are generally adjusted with changes in rates.

Implications for Equities

Stronger Growth and Low Inflation Support U.S. Stocks

Higher interest rates can be a headwind for equities. However, not all interest rate increases are the same. The reason rates rise is key to gauging their potential impact on stocks. If an increase is due to non-inflationary economic growth, which typically supports earnings growth, stocks may perform well. In fact, as outlined in Exhibit 3, history shows that periods with muted inflation in the 1-3% range have coincided with above-average P/E multiples.

Another important factor to consider is how P/E multiples perform in a low but rising rate environment. Historically, P/E multiples have expanded when the real yield on the 10-year Treasury has risen from low levels. It is only after the real yield hits 4% that P/E multiples begin to feel the pain and start contracting.

Exhibit 3 // Moderate Inflation Supportive of Equity Valuations

Average S&P 500 P/E by CPI Y/Y Tranche (1950 — Current)

Figure 3 // Moderate Inflation Supportive of Equity Valuations

S&P 500 P/E based on trailing four-quarter earnings. Source: StrategasRP

Further, low short-term rates may provide a near-term tailwind for equities, as companies benefit from stronger economic growth without a higher cost of debt. Even as short-term rates eventually climb, higher borrowing costs may represent just a muted threat, given that companies on average have far lower debt loads, with significantly higher cash on their balance sheets.

Since subdued inflationary growth typically occurs early in a tightening cycle, early-cycle rate hikes have often coincided with equity gains. As seen in Exhibit 4, the S&P 500 Index experienced a short-term pullback following the last four Fed Funds rate hikes before rebounding and delivering solid gains over the ensuing year.

Exhibit 4 // Strong Stock Market Returns Have Followed Rate Hikes

Average S&P 500 Returns Following the Last Four Fed Hikes

Figure 4 // Strong Stock Market Returns Have Followed Rate Hikes

Based on Fed Funds rate from 1/3/89 to 3/18/13, discount rate prior. Initial hike dates: 9/4/87, 2/4/94, 3/25/97, 6/30/99, 6/30/04. Source: Ned Davis Research

Of course, late-cycle hikes in the Fed Funds rate can pose a threat to equities since they signify a more restrictive Fed. These environments can be associated with excessive inflation and dampened economic growth. That is hardly the expectation at present. Rather, the near-term outlook is for the Fed to move from being aggressively stimulative to stimulative — a modest positioning change. It may be years before the Fed shifts to restrictive monetary policy, most likely at some point in 2017 but possibly not until 2018.

Given the backdrop of strong corporate balance sheets, low but normalizing interest rates and muted inflation, we believe equities should outperform fixed income. On a sector basis, a steepening yield curve should continue to benefit financials, which stand to profit on the spread between the short-term rates at which they borrow and the long-term rates at which they lend. As a healthier economy alleviates the Fed's need to inject stimulus, we would expect an improvement in the pace of earnings growth. We also would expect that cyclical sectors such as consumer discretionary, industrials and technology stocks would outperform defensive sectors.

Implications for Alternatives

Strategic Role in Any Environment

Alternative investments on their own certainly can entail significant risk, but as part of a diversified portfolio they can help investors achieve their objectives of growth, income and capital preservation. Alternatives have a low correlation to traditional assets such as stocks or bonds, and can therefore lower risk within a portfolio. Yet many investors have little to no exposure to alternatives. In most cases, these investments have a strategic role in a portfolio.

In the current interest rate environment, we think investors may benefit from alternative strategies that offer income replacement advantages and returns that are less sensitive to rising rates. Investors can also benefit from strategies that have potential for excess returns as a result of the strengthening global economy. It's important to note, however, that these investments are often complex, with varying liquidity profiles. As always, investors should have a thorough understanding of investment objectives and inherent risks before investing.

Compelling Choices among Liquid Alternatives

While equities have delivered strong returns in the current bull market, investors no doubt will recall their lackluster performance during the 10 years between 2002 and 2012. The so-called "lost decade" for equities was caused in part by two significant bear markets beginning in 2002 and 2008. Now, with the Fed's intention to end its quantitative easing program, the bond market has begun to feel the pain. Investors in these market environments can employ alternative strategies that can provide returns that are uncorrelated to equity and bond markets.

For example, long/short equity strategies can provide downside protection in periods of market swings while capturing a portion of the upside potential. They may also provide a cushion for investors if a shifting from easy to restrictive monetary policy triggers additional volatility.

In cases where both stocks and bonds turn negative, absolute return strategies may help by seeking to deliver returns in excess of cash in all market environments. In addition, these strategies can provide a return stream that is less correlated to fixed income investments amid rising rates.

Perhaps one of the greatest benefits of an alternatives strategy is its ability to be untethered to traditional market returns. Managed futures strategies, for example, offer the potential to capitalize on any trend, such as rising rates or inflationary pressures. It is up to the manager's investment acumen to identify a specific global trend that may be favorable. In particular, such strategies may offer attractive return potential later in a rising rate cycle when inflationary concerns increase and commodities stand to benefit.

Real estate investment trusts (REITs) are another type of alternative investment that offers appeal for investors who are searching for income. The low rate environment should support the earnings potential of these investments over the near term, even as they may benefit from higher valuations as the economy expands.

For certain qualified investors, private equity is a less liquid alternative investment that can also benefit from a stronger economy. While low interest rates have helped privately-held firms by way of lower borrowing costs, a rising rate environment is not necessarily bad for the private equity funds that buy a stake in them. As rates rise, deal prices can go down, creating favorable purchasing terms for private equity funds — particularly younger funds with cash to deploy. A stronger economy also supports the growth prospects of private companies, increasing their potential to reach a desired exit point.


Markets are transitioning to a less stimulative Federal Reserve, which ultimately may result in a dramatic shift in the fixed income landscape. Along with it will come new opportunities — and risks — across asset classes. Investors will need to consider the potential impact of this transition not just on fixed income holdings, but on equities and alternative investments. Now is the time to prepare for this shifting market environment.

Re-adjusting an investment portfolio for normalized interest rates will require serious examination and a holistic approach that encompasses a wider range of investment strategies across asset classes. Investors may need to make important modifications to ensure their portfolios are positioned to manage interest rate risk and capitalize on potential opportunities that will arise from shifts in the economy and markets. By making proactive adjustments to investment thinking and strategies, investors will have a higher likelihood for investment success in achieving their goals of growth, income and capital appreciation.


BNY Mellon Investment Management is one of the world's leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon's affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.

The statements and opinions expressed in this document are those of the authors as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This document is of general nature, does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon Asset Management International Limited and its affiliates are not responsible for any subsequent investment advice given based on the information supplied.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested.

While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for use by professional and wholesale investors only and not for onward distribution to, or to be relied upon by, retail investors.

Products or services described in this document are provided by BNY Mellon, its subsidiaries, affiliates or related companies and may be provided in various countries by one or more of these companies where authorized and regulated as required within each jurisdiction. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.

This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Asset Management International Limited.

In Australia, this document is issued by BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865) located at Level 6, 7-15 Macquarie Place, Sydney, NSW 2000. Authorized and regulated by the Australian Securities & Investments Commission. · In Brazil, this document is issued by BNY Mellon Serviços Financeiros DTVM S.A., Av. Presidente Wilson, 231, 11th floor, Rio de Janeiro, RJ, Brazil, CEP 20030-905. BNY Mellon Serviços Financeiros DTVM S.A. is a Financial Institution, duly authorized by the Brazilian Central Bank to provide securities distribution and by the Brazilian Securities and Exchange Commission (CVM) to provide securities portfolio managing services under Declaratory Act No. 4.620, issued on December 19, 1997. · Securities in Canada are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. · In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. · If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Investment Management Hong Kong Limited, whose business address is Suites 1201-5, Level 12 Three Pacific Place, 1 Queen's Road East, Hong Kong. BNY Mellon Investment Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. · In Japan, this document is issued by BNY Mellon Asset Management Japan Limited, Marunouchi Trust Tower Main Building, 1-8-3 Marunouchi Chiyoda-ku, Tokyo 100-0005, Japan. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. · In Korea, this document is issued by BNY Mellon IM Korea Limited for presentation to professional investors. BNY Mellon IM Korea Limited, 29F One IFC, 10 Gukegeumyung-ro, Yeongdeungpo-gu, Seoul, 150-945, Korea. Regulated by the Financial Supervisory Service. · In Singapore, this document is issued by BNY Mellon Investment Management Singapore Pte. Limited for presentation to accredited investors, institutional investors and family offices that are expert investors as defined under the Securities and Futures Act. BNY Mellon Investment Management Singapore Pte. Limited, One Temasek Avenue, #04-02 Millenia Tower, Singapore 039192. Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. · This document is issued in the UK and in mainland Europe, by BNY Mellon Asset Management International Limited, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. · This document is issued in the United States by BNY Mellon Investment Management.

BNY Mellon owns over 95% of the parent holding company of The Alcentra Group, which is comprised of the following affiliated investment advisers: Alcentra, Ltd and Alcentra NY, LLC.

BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation.

BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms' services or funds to any U.S. investor, or where otherwise unlawful.

BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People's Republic of China.

BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm.

BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the U.S.Newton Group ("Newton") is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S.

BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).

BNY Mellon Asset Management International Limited and any other BNY Mellon entity mentioned above are all ultimately owned by BNY Mellon, unless otherwise noted.

The information provided is for illustrative/educational purposes only. All investment strategies referenced in this material come with investment risks, including loss of value and/or loss of anticipated income. Past performance does not guarantee future results. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.

BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.

©2014 The Bank of New York Mellon Corporation. All rights reserved.