Why the Fed Will Stick to 'Low and Slow' on Interest Rates in 2017
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The economy isn’t the only thing picking up steam.
Inflation is expected to rise too, with consumer prices forecast to grow 2.3%, nearly double this year’s pace, according to the Blue Chip Economic Indicators survey. With higher inflation typically come higher interest rates.
But don’t worry about big jumps that could pump up your borrowing costs or clobber your bonds. Before the election, most economists expected two quarter-point rate hikes by the Federal Reserve in 2017. While Trump’s election could speed up or slow the pace, that is still a reasonable expectation. That means the Fed’s short-term rate target should stay close to 1%, four points below the historical average.
As yields inch up, households won’t have to sock away quite as much money to meet their goals. That means people will feel more comfortable spending.
Favor income stocks that can also grow
Some income investors frustrated by low bond yields have shifted into dividend-paying equities. But when rates do rise, people are likely to turn back to bonds, which means classic high-dividend payers such as utility stocks are a risk. “You want to stay away from interest-rate-sensitive stocks,” says Burt White, chief investment officer at LPL Financial. Indeed, as yields on 10-year Treasuries have jumped more than half a percentage point since July, utility stocks have already lost 6% of their value.
You don’t have to give up on dividends. Just shift into funds that balance decent yields with dividend growth. Christine Benz, director of personal finance at Morningstar, has recommended Schwab U.S. Dividend Equity ETF . The fund currently yields about 3% and has the lowest expenses among dividend-oriented ETFs, according to Morningstar.
Favor muni bonds
While bond prices move in the opposite direction of market interest rates, some forms of debt are less rate-sensitive than others. One such choice: tax-advantaged municipal bonds.
An uptick in economic activity and wages translates to higher tax receipts for the cities, counties, and states that issue muni bonds. Moreover, these bonds are starting off with higher yields than Treasuries, which allows them to weather rising rates better.
Calculator: Compare taxable, tax-deferred, and tax-free investment growth
Ten-year A-rated municipal bonds are yielding 2.2% on average, slightly higher than the 2.1% you’re getting on 10-year Treasuries. When you tack on the fact that muni-bond income is free of federal—and in some cases state—taxes, that 2.2% yield is actually the equivalent of 2.9% if you’re in the 25% federal income tax bracket, and 3.3% if you’re in the 33% bracket.
There’s one more reason to go with munis in 2017. With President-elect Trump promising major infrastructure spending during the campaign—he alluded to more than $500 billion—and his party controlling both houses of Congress, the likelihood that Washington embarks on a new round of stimulus spending is rising. Spath of Sierra Investment Management notes that any push for national infrastructure spending is likely to create “huge increases in demand” for munis, which fund such projects.
One of the cheapest and most effective ways to get broad-based exposure is through Vanguard Intermediate-Term Tax Exempt Fund , which charges expenses of just 0.2%.