Few Surprises from the Fed

By Bryan Perry

The much-anticipated June meeting of the Federal Open Market Committee (FOMC) came and went with few if any surprises. The U.S. markets applauded accordingly by charging back up to the high end of the range, with the Nasdaq posting a new all-time high in the process. The text of the Fed statement was virtually unchanged from the March meeting, except for a small upgrade for current economic conditions. The second item was the economic outlook, in which the Fed mildly raised its view of growth for 2016 and 2017. But most significant to the market was the dot plot where the Fed predicted a much shallower hiking path.

During the post-meeting question-and-answer session, Fed Chair Janet Yellen confirmed the gradual path of interest-rate tightening. She stated that we should focus not on when the Fed may start to raise rates, but rather focus on the pace of any rate hikes. She also mentioned the strong dollar as a reason the Fed wants to take a more gradual approach. The near-term reaction from the market is what investors should expect from such a dovish Fed statement. The dollar weakened and equities rallied.

Longer term, this situation does not alter my view for the fixed income market. I expect more volatility as the Fed struggles to normalize rates where there are late-cycle credit dynamics that justify caution on long-term maturities in credit markets. I expect the Fed to raise rates just once in 2015. This dovish, gradual approach to monetary policy is not surprising. For the past five to six years, the Fed has continued to operate behind the curve instead of being pre-emptive in raising rates.

The Fed has blown through its guideposts for unemployment and inflation. Last year, the Fed abandoned a labor indicator with 19 subcomponents that could have triggered a bump in the Fed Funds Rate. Instead, the Fed pointed to a strong dollar to delay hiking rates. Both Fed actions support higher asset prices. Although the market got what it wanted, there is material weakness in the energy, transportation, retail, materials and industrial sectors. That weakness keeps the current rally narrowly focused on technology, healthcare, media and financials. There are definitely opportunities to make money, but it???s more selective.

A selective approach for income investors is highly warranted against this backdrop of an eventual rate hike or two hikes during the next six to nine months. This slow-and-steady approach is especially positive for floating-rate and adjustable-rate securities, as most of the loans and mortgages held in portfolios are reset every six months. If rates pop too quickly, stocks of mortgage real estate investment trusts (REITs) that own adjustable-rate mortgages and business development companies (BDCs) that own floating-rate senior secured loans typically will be pressured lower because they can???t react right away to sudden changes.

However, when rates are being raised incrementally, then these types of assets should thrive because the timetable fits with the types of securities held in portfolios that are crafted for higher rates. Cash Machine???s model portfolio is structured for this very specific investing landscape, holding several core positions in floating-rate and adjustable-rate REITs and BDCs. One position in the Conservative High-Yield Portfolio couldn???t be named any better: PennantPark Floating Rate Capital (PFLT).

The company is a business development company which primarily invests in U.S. middle-market private companies in the form of floating-rate senior secured loans. The stock pays a current dividend yield of 8.10% and generates a monthly dividend as opposed to a quarterly payout, as is the case with most BDCs. It is exactly this kind of high-yield stock that is poised to perform well in this market, and it has been trading in a tight range for the past year. Every good stock gets its turn to shine, and for PFLT, it???s now.

In case you missed it, I encourage you to read my e-letter column from last week about a stock shortlist for when the Fed raises interest rates. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.

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