Think of stocks and bonds as competing for investor money. The characteristics of each investment is very different but if we look at one factor associated with each the competitive nature becomes clear. I am referring to dividend yield and interest yield. For much of the current recovery stock dividend yields have been more attractive than bonds. Not because dividend yields are high but because interest rates are abnormally low.
With the Federal Reserve looking to make another interest rate hike investors recognize that bonds could become more competitive for investment dollars relative to stocks. For example, here is the current yield for the Dow Jones Industrial ETF (DIA) compared to the current yield for the U.S. Aggregate Bond ETF (AGG).
Note: There are many methods for calculating yield. The methods calculated by the investment sponsors above are believed to be similar.
We can agree, current yields are pathetic. Gone are the days for a reliable 3-4% dividend yield and 5-6% interest yield for high quality stocks and bonds. The point is, with interest rates potentially moving higher bonds may become a more attractive investment for income.
The primary factor driving Fed policy at the moment is the “normalization” of interest rates and not a response to an overheating economy – the usual reason The Fed raises rates. By normalization, what The Fed is really trying to accomplish is getting rates high enough that when the next economic slowdown arrives they can “lower rates” again to stimulate the economy. The reason The Fed has been slow in raising rates is they don’t want to disrupt our fragile economic recovery.
Given current conditions, The Fed will be lucky to get short-term rates over 1% before the next recession hits. However, with a new administration occupying the White House in 2017, economic conditions could change in either direction. If we slip into a recession rates will be cut but from already low levels. If the economy is able to shift into a higher gear it will be much easier for The Fed to move rates higher. However, the economic challenges we face are more structural than financial (as evident over the last 8 years). Until those issues are resolved I would expect any interest rate hikes to be limited.