Jack Meskunas, Oppenheimer & Co
Given the Democrats’ control of the house, senate, and executive it seems unlikely we will see a rate increase in 2022, says Jack Meskunas of Oppenheimer.
There is only one question on the mind of everyone who manages money, has money in the market, or who watches the markets: when will the Fed lift off? By “lift off” we mean when will the Fed move from the long-held zero-interest-rate policy and raise rates for the first time since the start of the COVID-19 pandemic?
Captive owners, captive managers, and financial advisors working with captives all know the importance of not only the level of interest rates, but more importantly their direction. What is interesting and more important than the current level of rates is where rates are heading. Are rates going up, going down, or expected to be about the same, and during what time period?
The level of rates sets the current prices of fixed income investments. The direction of interest rate movements expected in the market affects credit spreads (how much increased interest you pick up as you move down the credit quality ratings) as well as stock prices and multiples. Reading these anticipated movements is instrumental in knowing whether the captive’s assets are appropriately placed, or if tweaking or reallocation of the portfolio is necessary.
The Federal Reserve publishes a survey of anticipated rates. In its “dot plot” (Figure 1) the Fed publishes the minutes and notes from its meetings. Everyone goes to the “dot plot” to see where each Fed governor thinks the appropriate level of rates should be currently, for 2022, 2023, 2024, and for the longer term.
Figure 1: Federal Open Market Committee September 2021 dot plot
Of course they never talk about “whose dot is whose”. Look at Figure 1 to see what the Fed is thinking. All 18 dots are at zero for 2021, for 2022 six dots are at 0.25 percent and three are at 0.50 percent. For 2023 they start spreading out. Only one dot remains at 0 percent (this is called “dovish”) and three dots are as high as 1.5 percent (these are called “hawkish”). The rest—of course—are in between, with the most dots lying on the 1 percent mark. In 2024 most of the dots are on the 2 percent mark. These rates could be used to approximate what investors could expect to earn on overnight (money-market) deposits.
Not to be outdone, strategists and economists from Wall Street and the major world banks also try to predict where interest rates will go. Most strategists, economists, and television business news talking heads are saying rates will rise somewhere between 1.5 times and 3 times in 2022.
Typically when the Fed raises rates, it lifts 25bp at a time (+0.25 percent increments). So these prognosticators think short-term rates will move from where they are now at 0 percent to around 0.375 percent to 0.75 percent in 2022.
“Many people think that the Fed will not raise rates in an election year, but that is simply not true.” Jack Meskunas, Oppenheimer
I have another thought, however: it’s ‘23 and me (and you and the Fed)!
One needs to understand why the Fed raises rates and what the effects of higher rates are on stock and bond prices, and then couch this all with the full knowledge that the US elections in 2022 will likely be the most important and influential mid-term elections ever. Let’s look at each of these items individually.
The Fed raises rates to slow or “cool” the economy. In reality it is the Federal Reserve and its policies—including raising rates—that have caused most of the recessions in this country. What factors does the Fed review? See Table 1.
Table 1: Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy, September 2021.
Note: Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. Personal consumption expenditure (PCE) inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for PCE and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. The June projections were made in conjunction with the meeting of the Federal Open Market Committee on June 15–16, 2021. One participant did not submit longer-run projections for the change in real GDP, the unemployment rate, or the federal funds rate in conjunction with the June 15–16, 2021, meeting, and one participant did not submit such projections in conjunction with the September 21–22, 2021, meeting.
- For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle
- The central tendency excludes the three highest and three lowest projections for each variable in each
- The range for a variable in a given year includes all participants’ projections, from lowest to highest, for that variable in that
- Longer-run projections for core PCE inflation are not
They look at personal consumption expenditure (PCE) and “core” inflation, changes in gross domestic product, unemployment rates and many other factors. The biggest factor is said to be the inflation numbers, with the Fed having a stated goal of keeping inflation at around 2 percent.
Inflation most simply is higher prices. Stocks like inflation—it means the prices of goods and services are increasing—if they are well-managed and can control their costs, the result is higher profits. Higher profits lead to higher stock prices.
Excessively high inflation is not good. It leads to panic buying, higher costs for all—including companies—and eventually lower employment. These factors lead to recession which tempers and reduces inflation until prices stabilise and eventually the cycle can repeat.
Higher interest rates and bond prices
In general, as rates go higher, bond prices go lower. Government bonds which are considered riskless from a credit perspective are directly correlated. Higher rates = lower bond prices; lower rates = higher bond prices. For corporate bonds which by definition have credit risk the price movements are not fully correlated, because rates usually rise when the economy is doing better and growing.
For well-run companies, the increased sales and profits generally translate to better credit quality and rating-agency upgrades. As bond ratings increase from “junk” status (BB+ or below) to “investment grade” (BBB- and above) the prices of bonds increase as well.
Last—but not least—are the elections. Many people think that the Fed will not raise rates in an election year, but that is simply not true. In the last 40 years the Fed has raised rates over 60 times, with roughly one third of those increases during election years.
I think “this time might be different”. I believe that the Fed is under tremendous pressure from the Executive Branch, including former Fed chair Janet Yellen, not to raise rates before the 2022 midterm elections. This is even more of a possibility given the drubbing the Democrats took in the “off year” 2021 elections. Given their control of the house, senate, and executive it seems unlikely we will see a rate increase in 2022. That is why I say ‘23 and Me.
Meanwhile, for captive insurance company portfolios, I believe that “staying the course” in a portfolio of well-managed corporate bonds, balanced if possible around the cusp of Investment Grade and High Yield, offers the greatest opportunity for the foreseeable future to experience growth in the price and value of their bond portfolios, inflation protection, and locking in reasonable cash-on-cash yields.
Jack Meskunas is executive director–investments at Oppenheimer & Co. He can be contacted at: email@example.com
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