Don’t try to predict long-term rates

It’s important to be aware of potential Federal Reserve interest rate changes. But don’t move based on where you think rates may go.

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So says Ignacio Sosa, director of the product solutions group at DoubleLine Capital in Los Angeles. “In our fixed-income strategies, [we] look at interest rates and try to manage our portfolios in accordance with our interest rate view, but we do not target a certain level of interest rates as a driver of excess returns.”

One reason for that is it’s “almost impossible to predict long-term interest rates accurately,” he says. “Secondly, even if you do, targeting a specific level of long-term interest rates will add unnecessary volatility.”

That said, “Our interest rate view does in fact impact our asset allocation decisions, particularly in a flexible income type of strategy,” says Sosa, whose firm manages the Renaissance Flexible Yield Fund.

In the Fed’s recent rate announcement — of its third hike in only six months — Sosa noticed the language in the communication regarding the June rate hike was more hawkish than had been expected.

Read: Fed hike reflects comfort with the U.S. economy

Sosa found that surprising because “it’s pretty clear to us that inflation has peaked in 2017,” he says. “In fact, using our own internal models, if oil stays where it is right now, we would expect inflation by the end of 2017 to be around 1.6%.”

The Fed’s target rate of inflation is between 1% and 1.25%, versus the 1.6% that Sosa forecasts. As such, he says, “It would imply that there’s not a lot of room to increase rates much more than this, unless you want much higher real rates—which we don’t think the Fed wants. So when you look at what markets are predicting for the rest of this year in terms of rate hikes, it’s a mixed bag.”

Read: Unexpected inflation slowdown could stall Fed later this year

One tool Sosa uses is the world interest rate probability function on Bloomberg. “I look at [the probability of] rate increases for the rest of this year as vacillating quite widely in the U.S., anywhere from one-third to 45%, but it’s not a big bet that they’re going to go up much more than this.”

If the Fed were to raise rates, he adds, “we think there’s a likelihood that they would do it by the end of this year. But it’s not a slam dunk by any means.”

Sosa also suggests it’s unnecessary to overanalyze the run-off in the Fed’s balance sheets. “In other words, [that refers to] the continued move by the Fed to try to reduce the number of Treasury­ – and to a lesser extent mortgage — holdings they have.” In the short-term, he predicts that “will have less of an impact.”

That might change, however, if oil prices were to rise sustainably, says Sosa. But “we don’t think is going to happen. Another thing could be that the fiscal side of the equation turns much more aggressive; in other words, the government decides to greatly increase its spending on infrastructure, defence or any other items.”

But this is also unlikely, he adds, “given the problems that the Trump administration is having in Washington. So I look at the factors that are out there and, first of all, there aren’t really very many [factors] from a Fed point of view that would trigger the consensus to raise rates because inflation is an imminent threat.”

Looking at longer-term rates, Sosa says, “We do believe we have seen the lows.” Since 2012, he points out, “[rates] have slowly been going up and will probably continue to slowly go up. The question is how fast and how high and, for the near term, it doesn’t look like they’re going to go much higher. But the trend is higher, not lower.”

On the future of the Fed, he’s unsure. However, he says, “It wouldn’t surprise us if Chairman Yellen was replaced, and that that person more than anything would more likely be less hawkish.”

Read:

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