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Why Recent Fed Action Signals the Economy Is on Solid Ground

Ron Joelson •  June 27, 2017 | Ask the Expert, Your Finances

Each month, we book time with some of our company’s top financial brain power to answer questions about investing and your finances. This month we’re talking about the Fed’s recent moves and what they mean for the economy.

Ron Joelson

Ron Joelson is Northwestern Mutual's chief investment officer and oversees the company's general account, valued at approximately $200 billion as of June 2016.

Mark McLennon

Mark McLennon is vice president of Investment Products and Services (IPS) Business Development. He oversees the fee-based financial planning program and departmental growth initiatives.

Brent Schutte

Brent Schutte is chief investment strategist of Northwestern Mutual Wealth Management Company. He oversees the investment philosophy for individual retail investors and the investment strategy for more than $100 billion in assets under management as of December 2016.

Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com

The following is an excerpt from our Ask the Financial Expert podcast (listen to the entire podcast below):

Mark: The Federal Reserve just raised interest rates for the third time since December. But they also talked about selling some of the bonds they had been buying. Ron, what does that mean moving forward?

Ron: I’m very pleased with the Fed’s direction. It really feels like it’s thinking about the fundamentals of the economy and thinking more long term. I think the Fed representatives themselves might say they’ve always been that way. But in the past it has looked more like they’ve been very concerned about short-term market fluctuations and slowing the pace of rate moves.

Now they seem to be a on a regular rhythm that’s reflective of the belief that the economy is on very solid footing, which we agree with. For instance, when inflation numbers came out a little bit lower in the last two months, the Fed still decided to raise rates. In the past, that kind of hiccup may have given the Fed pause.

Brent: I think the Fed is looking beyond the hiccup in inflation and considering things like the 4.3 percent unemployment rate. Eventually, that kind of low unemployment will cause wages to increase, and that will eventually lead to inflation – at least that’s what the textbook would tell you. We still think that will happen. It’s just taking a longer time to get there because the scars of the recession were so deep that people have behaved somewhat differently.

Some people are screaming the that the Fed shouldn’t have hiked rates. I disagree. Monetary policy is still very accommodative. But at the same time, the Fed needs to get to get ahead of the economy a bit so that when it does start heating up, the Fed’s not in a position where it has to raise rates so fast that it causes market problems or even throws the economy into recession.

Ron: In addition to raising rates, the Fed also scheduled out how it will begin selling Treasuries and mortgage-backed securities it has been buying to increase prices and lower rates in the medium term and the long-term part of the yield curve. That should start to raise medium- and long-term interest rates, which will steepen the yield curve.

However – and Brent and I may disagree here – I think the effect will be very muted because there is high demand for fixed income assets from all over the world. I think there’s more than enough capacity out there to pick up the slack and purchase the securities the Fed will no longer be buying.

Brent: My take on that is nuanced. I don’t disagree that there’s a ton of demand. But the demand will come from real investors who are more price sensitive than the Fed. My question is whether real investors, who see perhaps inflation of 2 percent, still find a 10-year treasury yield at 2.15 percent as an attractive investment for that time period. I also think we can’t ignore that the Fed has counterparts in Europe and Japan who have been doing the same thing.

Ron: This may signal the basis for a global recovery, which could lead to higher rates around the world; we’re starting to see that in Europe. Countries around the world are much better financially than they have been in the past, and it appears to be real. Buyers who are coming out of the woodwork for U.S. Treasuries and U.S. paper may well feel like they’ll be able to get as good a deal in other countries. Then the Fed moves could result in an even higher yield curve. We’ll have to see which way that unfolds.

Mark: Could this be that kind of long-term, upward trend that we’ve been waiting to happen? The ECB (European Central Bank) has declared no more cuts; and the Fed has said they’ll raise rates three more times in 2018, and it’s selling the bonds it has been buying. Is this the ultimate lift of rates that we’ve been hoping would come? And now it’s going to be more about fundamentals than listening to the noise?

Ron: I would say “Be careful” because the Fed has had a lot to do with prior downturns by moving too quickly. So I wouldn’t word it that way. It’s that the Fed is reacting appropriately to a global situation. If the Fed moves too much, it could cause economic problems. We’re hoping for this very gradual kind of move on the part of the Fed, which I think is what’s happening. If they were to move too quickly, I think we would be pretty concerned.

Brent: I worry about them moving too slowly. Janet Yellen said the Fed doesn’t want to cause a problem by raising rates faster than the market expects if people go back to taking on too much debt. I think that’s why they’re raising rates now, so they can be gradual just in case the economy does return to the old recipe where consumers take on too much debt or companies overinvest.

Ron: We are starting to see some signs of it. We’re seeing slightly higher consumer default rates and a bit more leverage in the corporate markets. But it’s nothing compared to the kind of late-cycle credit explosion like we’ve seen in the past.

Hear more from Ron, Brent and Mark in the “Ask the Financial Expert” podcast:

Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com

The opinions expressed are those of individual investment professionals as of the date stated on this article and are subject to change. This material does not constitute investment advice, is not intended as an endorsement of any specific investment or security and is not a prediction of what will happen in the markets.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise; and conversely, when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels, there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates and are not obligated to return the investor’s principal. Additionally, high-yield bonds and bond funds that invest in high-yield bonds present greater credit risk than investment-grade bonds. Bond and bond fund investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.

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