The Federal Reserve voted to leave interest rates alone at its September meeting. Nevertheless, investors should not get too comfortable because a December rate hike is very much on the table, said Colin Martin, director of fixed income at Charles Schwab (SCHW - Get Report) .
Martin believes a hike in December is still likely because economic data, while having slowed a bit recently from earlier this year, appear to be good enough. Inflation appears to be trending in the right direction, with CPI rising by 1.1% in August, with core CPI rising by 2.3%, matching the high of the post-crisis recovery.
He added the yield curve has been getting steeper lately after being in a declining trend for over two years. In the short run, he thinks it can continue to steepen more.
"We think much of the rise in long-term bond yields has been driven by the term premium as the market appears a bit concerned that global central banks may not continue to expand their QE policies," said Martin. "Ten-year Treasury yields began the year close to 2.3%, so there is room for yields to move higher. Over the long run, however, we still see forces that can keep long-term yields from rising too much further from here."
Martin recommends investors shorten their average duration since he does see short-term yields rising more. He also advocates floating-rate investments because the coupons on investment grade floaters can reset higher once the Fed hikes rates again, and their prices are relatively stable due to their high credit quality and low duration.
"We're also more favorable on bank loans these days, since three-month [London Interbank Offered Rate] is approaching 1%, where many loans have floors," said Martin. "That means that once Libor goes above that level, the coupons on most bank loans should finally reset higher."
Finally, Martin is a fan of Treasury Inflation-Protected Securities, or TIPS, due to their valuations and because break-even rates are well below their historical average and below the Fed's 2% target.
"While most inflation readings are still below 2%, they are moving in the right direction. If you're for inflation protection, the price looks attractive today," said Martin.
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