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Reading the Fed: What's the next move?

May 10, 2013

In the wake of the latest two-day meeting of the Federal Reserve's Open Market Committee (FOMC), we caught up with Vanguard senior economist Roger Aliaga-Díaz for insight on the Fed's direction and what it means for investors.

You've read the FOMC minutes. What's the Fed's next move to spur economic growth?

Roger Aliaga-DiazThe Fed has stated clearly that all options remain on the table in terms of the speed of asset purchases. It could increase or decrease its current monthly buying pace of $85 billion.

To my ears, the implication is that the Fed is prepared to step up the purchases if the economic slowdown continues and morphs into another summer soft patch. The FOMC is saving itself some room to maneuver if, as expected, tax increases at the beginning of the year, spending cuts due to sequestration, and the "policy uncertainty tax" combine to exert maximum drag on the economy toward the middle of 2013.

How might unemployment move the dial on interest rates?

Longer term, the FOMC is sticking to the target unemployment rate of 6.5% as a precondition for the "lift-off" of interest rates. There was some speculation among investors and economists that the Fed would specify an additional target that would trigger a stop in asset purchases. However, the committee has clearly signaled it is sticking to its original framework. Our view is that by the time the unemployment target is reached and we start talking about rising rates, the Fed will have already stopped or considerably slowed down asset purchases.

Given the conditions we face, how can investors position themselves for success?

At present, our consensus expectations for medium-term real GDP growth and inflation are consistent with rates rising gradually over a period of at least five years. However, when it comes to predicting interest rates, the large number of unknowns involved means unexpected surprises may arise.

That's why we recommend two long-term strategies: maintain wide diversification in bond portfolios across maturities and market segments, and make sure to keep a good balance between fixed income and equities. If rates go up faster than expected due to a strong economy, fixed income assets may not do that well. However, within them, your corporate bonds should perform relatively well, and, more important, equities should more than compensate for the losses on the bond side. If rates stay low or decrease due to a severe slowdown, long-term U.S. Treasuries should thrive.

Notes:

  • All investments, including a portfolio's current and future holdings, are subject to risk, including the loss of principal.
  • Diversification does not ensure a profit or protect against a loss.
  • Bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

 

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