Investors turn cautious as Fed edges toward rate increases

WASHINGTON - This is not the moment the Federal Reserve will start to raise interest rates. But that day is coming, and investors are getting nervous.

Karissa McDonough, director of fixed-income strategy for People's United Wealth Management, the investment arm of a Connecticut bank, said her firm had chased higher returns in recent years by amassing assets like emerging-market debt and high-yield bonds that it would not have considered a decade ago.

She thinks "all the time" about selling those assets and heading for safety. The firm sold some in January. But she does not want to retreat too soon.

"We're all looking at each other to figure out who's going to blink first," McDonough said. "You don't want to give up while the market is still strong and supportive. You'd be giving up on a significant amount of income."

The Fed and the central banks of the major European and Asian economies have presided over an extraordinary period of low interest rates and minimal volatility, seeking to increase economic growth by encouraging risk-taking.

Now the Fed is poised to become the first of its peers to head for the exit. Fed officials, who are meeting this week, have said they would like to start raising short-term rates later this year, lifting the Fed's benchmark rate from its hibernation near zero for the first time since December 2008. Janet Yellen, the Fed's chair, will discuss the policy at a news conference Wednesday after the Fed wraps up its conclave.

Fed officials have portrayed these plans as a testament to the progress of the economic recovery, and they have emphasized they plan to raise rates slowly - more slowly than the Fed's past practice - so that they do not put the brakes on growth too soon.

Some aren't nervous

Not everyone is worried. Richard Davis, chief executive of U.S. Bancorp, argues that raising rates could actually help encourage growth, at least for a while, by spurring companies and individuals to borrow money ahead of higher rates in the future, just as potential home buyers often plunge into the market only after mortgage rates start to rise.

But whatever the effect on the economy, Fed officials have emphasized that they expect rate increases to disrupt financial markets, increasing volatility after a long period of tranquility.

"My own view is that there likely will be some turbulence," William Dudley, the president of the Federal Reserve Bank of New York, said this month. "After all, liftoff will represent a regime change after more than six years at the zero lower bound."

McDonough said she worried particularly about the flight of investors who have entered new markets since the crisis, and have never experienced the kind of volatility that disrupts trading even during periods of normal activity.

'Junkiest investors'

"My fear is that the junkiest investors will no longer have access to capital and that all of that money is going to fly out and exacerbate this tightening," she said. "I'm not worried about the Fed moving too early in terms of the U.S. economy. I am very concerned about the market impact."

Gibson Smith, an investment officer at Janus Capital Group, said his firm was positioning itself to take advantage of the fire sales that might result as sellers cut prices to attract scarce buyers.

Smith said Janus was reducing its holdings of high-yield debt and its exposure to the mortgage market, and instead was accumulating easy-to-sell short-term Treasurys.

"There is a high level of complacency among investors right now," he said. "In their quests for yield they are really turning their heads to some of the risks that exist."

Smith said Janus would make less money thanrivals if the Fed continued to postpone rate increases, or if the market reaction was relatively calm, but he said the foregone opportunity was small compared to the risks.

"There are times when it is very important to be defensive and cautious, and that's what we're doing with our portfolios right now," he said.

Others, however, are standing pat, regarding the fears of disruption as overstated.

John Bellows, a portfolio manager at Western Asset Management, said that he did not regard investors as overly complacent. He said current prices largely reflected economic conditions, and he did not think the Fed would seriously disrupt markets by modestly increasing its benchmark interest rate.

"It wouldn't surprise me to see a little volatility, but even over a month or a few months' time frame I think the economic fundamentals will drive markets," he said. "Inflation is quite low, growth is not accelerating and central banks around the world are easing."