How might investors position their portfolios for a trend of higher long-term interest rates?

The Federal Reserve recently released minutes from its late January meeting that confirmed the central bank took a near 180-degree turn in its interest rate policy, pausing on rate hikes and doing its best to ease financial conditions after a volatile December.

While the analysis gets pretty complex, the bottom line for investors is that the shift in Fed policy could lead to higher long-term interest rates, which could be beneficial for banks and financial stocks, but negative for longer term bonds. 

Read on as I connect the dots between Fed policy moves and your portfolio:

The meeting minutes suggest that in reaction to slowing global growth and volatile December markets, the Fed sought to create easier financial conditions for businesses and the economy. It decided to pause its plans to keep hiking short-term rates, which are still historically low. It also decided to slow its effort to shrink its balance sheet by letting the proceeds from maturing bonds run off, a process known as quantitative tightening.

Here’s the counterintuitive part: While these are dovish monetary policy moves, which typically lead to lower interest rates, my analysis suggests they could lead instead to higher long-term rates. That’s because investors will likely be quick to price in the potential that, thanks to the dovish policy, economic growth will improve and inflation rise.

That could cause longer-term rates to drift higher, even as short-term rates stay low.

Since bond prices move inversely to interest rates, I don’t think this is a good time for investors to buy longer-term bonds. However, financial firms typically benefit from a steepening yield curve, making that potentially a sector worth adding to.

Generally, however, I suggest investors remain cautious about other sectors and when adding to equity holdings, use active rather than passive strategies.

Stock market returns usually correlate with yields, but that relationship seems to be breaking down. We are late in the business cycle and investors may not be willing to pay more for stocks when earnings growth is likely to stall. Contrary to the old adage, when it comes to yields and stocks, a rising tide may not lift all boats.

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