This article was written by PowerShares Director of Fixed Income Strategy Scott Eldridge.
The threat of higher interest rates is dominating many 2015 outlooks for investors and professional forecasters alike. Consensus expectations call for the Federal Reserve (Fed) to begin tightening in the second half of the year, with market rates to rise in concert and bond prices to fall. But the changing composition of voting members on the Federal Open Market Committee (FOMC) is a looming variable that I believe will likely impact the pace and severity of Fed action.
A more dovish Fed favoring low interest rate— combined with indications of global economic slowdown and falling asset prices — may translate into a more benign rate environment for 2015 than expected. With this in mind, investors may want to reconsider stripping away all interest rate exposure from their income allocation and instead consider a more diversified and balanced maturity structure.
FOMC rotation favors dovish views
In my view, the January 2015 changes to the membership of the FOMC will bring about an even more dovish weighting to voting, based on historical voting patterns and public comments made by members.
- Three voters viewed as hawks or hawkish because they favor higher interest rates — Charles Plosser, Richard Fisher and Loretta Mester — are rotating off.
- The only dovish voter stepping aside is Narayana Kocherlakota, who actually has a fairly balanced history of voting patterns.
- Committee additions include three with dovish views: Charles Evans, Dennis Lockhart and John Williams.
- President Barack Obama can fill two additional vacancies, and I would expect his appointments to carry dovish inclinations.
- Jeffrey Lacker, who has expressed very hawkish views, also joins the FOMC, but he will likely be the loner at that end of the spectrum.
FOMC 2015: Dominant Doves May Create a More Patient Fed
Implications for investors
If a more dovish Fed takes a slower, steadier approach to tightening than anticipated, fixed investments with longer average durations may not be the portfolio-killers they might otherwise be in an environment where the interest rate rises more rapidly. In fact, peppering portfolios with some exposure to longer duration may offer an opportunity for enhanced yield and total return, as well as diversification from equity risk. While a fixed income allocation built for Fed tightening may still be appropriate for many investors, blending a little duration into a portfolio may be beneficial if rates once again defy expectations and continue to fall.
Adding duration into a fixed income allocation
After talking to their financial advisors, investors may want to consider increasing their exposure to high-quality, longer-duration strategies. For example:
- PowerShares Build America Bond Portfolio (BAB), tracks an underlying index that invests in taxable municipal securities. BAB, which carried duration of roughly nine years as of Dec. 31, 2014.
- PowerShares National AMT-Free Municipal Bond Portfolio (PZA)* offers tax-efficient exposure to duration in an uncertain tax environment. PZA showed duration of eight years as of Dec. 31, 2014.
- PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) offers duration exposure for investors willing to accept emerging market exposure. PCY’s underlying index invests in a portfolio of emerging market sovereign debt denominated in US dollars, and the fund carried duration of nine years as of Dec. 31, 2014.