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Stocks and Bonds Can Weather a Fed Rate Increase, Investors Say

Moves in dollar and oil, along with improved U.S. economy, should help markets avoid turmoil, fund managers say

Stock and bond markets appear ready to absorb the next Federal Reserve rate increase without descending into turmoil, fund managers say, reflecting economic shifts and investor positioning since the last Fed move in December.

Fears of another market tantrum arose last week after Fed officials repeatedly warned that investors were underestimating the likelihood of a rise in the fed-funds rate at the central bank’s June 14-15 meeting. The 10-year Treasury yield posted its largest one-day rise this year on Wednesday following the release of minutes saying the Fed could raise rates next month if economic growth continues. Yields rise when prices fall.

Yet many portfolio managers say upheaval appears unlikely. One reason, they say, is that the dollar and oil are both offering markets much more comfort than they did as recently as last year.

After rising significantly over the past two years, the WSJ Dollar Index, which measures the greenback against a basket of currencies, is down 2.9% for 2016, relieving pressure on the earnings of large U.S. companies and the finances of many emerging-market nations that have borrowed in dollars. Oil has rallied 82% from its 2016 low amid supply disruptions, taking pressure off U.S. energy producers and likely limiting further ripple effects from the crude collapse.

A sharp selloff in stocks and bonds during the first six weeks of the year largely stemmed from fears the U.S. could be headed into recession. But several recent gauges of U.S. economic health, measuring industrial output, housing sales and consumer prices, have shown growing momentum. Wages have picked up after a long period of stagnant growth, but inflation broadly appears soft, likely giving the Fed room to raise rates only gradually.

These factors, together with the declines over the past month in stock and bond prices, mean the market can handle a well-telegraphed rate increase, many investors say—the only kind most analysts believe the Fed would dare attempt.

“There is a lot of money globally chasing very few high-quality assets,” said Mark MacQueen, co-founder and portfolio manager at Sage Advisory Services Ltd., which oversees $12 billion. He said a quarter-point rise in the fed-funds rate likely won’t change that dynamic, and that he might buy U.S. government bonds if the Fed raises rates.

Concerns about a stock-market pullback in response to future rate increases often center on soft corporate earnings and extended valuations. But some analysts see signs in this year’s energy recovery that the picture could be brightening.

First-quarter earnings for U.S. companies were poor, but “that may have been a nadir," said Ben Mandel, global strategist at J.P. Morgan Asset Management. He believes U.S. stocks could offer mid-single-digit annual returns by the end of this year. The S&P 500 index is up 0.4% so far in 2016.

Nor are investors overly worried about big price declines in U.S. government debt. Central banks in Europe and Japan have pushed their benchmark interest rates into negative territory in a bid to boost economic growth there, making U.S. Treasurys more attractive for foreign buyers. Demand from those investors is expected to keep prices on longer-term bonds steady, even as others sell short-term Treasurys, which are typically most sensitive to Fed policy.

In another sign of the improved market tone since January, U.S. corporate-bond sales—even those from risky, highly levered companies—have picked up in recent months. Corporate-debt sales largely came to a halt earlier in the year, as jittery investors refused to lend money amid the market turmoil. But the market has opened up again, allowing a relatively low-rated company like Dell Inc. to sell $20 billion of investment-grade debt last week, the fourth-largest corporate-bond deal on record.

Data from the Commodity Futures Trading Commission released Friday showed investors were growing more optimistic in certain parts of the market, underscoring the positive tone. Bullish bets by speculators on crude oil and long-term Treasurys increased while bearish bets declined, according to the data, which reflects positioning as of May 17.

Investors have readjusted their interest-rate expectations significantly in recent days. About a week ago, interest-rate futures priced in just a 4% chance that the Fed would raise rates in June, according to CME Group. But the odds rose to 26% by Friday.

The yield on the two-year Treasury note, highly sensitive to the Fed’s policy outlook, rose by 0.13 percentage point last week to settle at 0.888%, the biggest weekly increase since November. The WSJ Dollar Index rose 0.8% last week.

Not all investors are sounding the all clear. Despite the positive economic data in recent weeks, U.S. economic growth clocked in at a lackluster 0.5% in the first quarter. Concerns remain about the pace of economic growth in China, and a further slowdown there could reduce demand for commodities, lowering prices and renewing pressure on energy and mining firms. CFTC data show an uptick in bearish bets on the 10-year U.S. Treasury, whose yield has risen to 1.85% after earlier declines.

But David Donabedian, chief investment officer of Atlantic Trust Private Wealth Management, which had $27 billion of assets under management at the end of April, said any selloff likely would afford many investors the opportunity to hunt for value from beaten-down assets.

"No matter whether the Fed raises rates in June, July or later, the key point is that the Fed is in for a very slow pace of normalizing its interest-rate policy, which is not the stuff that would push stocks into a bear market,’’ he said.