The party's over: What do bond investors do now?

The U.S. Federal Reserve ended seven years of zero interest rates on Wednesday with a quarter-point increase in the federal-funds rate, taking away the proverbial punch bowl. While a rate hike is finally coming to fruition, it arrives three months late and that could mean Janet Yellen spends 2016 catching up.

Punch Bowl
Joe McDaniel | Getty Images

In September, the Fed had a chance to reduce uncertainty and begin the long road to policy normalization. If you listened to Fed speeches over the summer, the central bank appeared poised to raise rates in September. But Yellen backtracked — citing international developments and financial-market turmoil, neither of which are part of its dual mandate — injecting additional uncertainty and underscoring her poor handling of messaging the Fed's intentions. One area where Yellen has been consistent, however, is saying that once tightening begins, policy makers will take each decision employing a methodical, data-dependent approach.

That's all well and good, but it's a problem if the Fed is already late. That could be the case because conditions in the U.S. economy are ripe for an inflation surprise over the next six months. Indeed, it could already be happening. The U.S. real-estate market is strong thanks to low mortgage rates and a robust job market. Unemployment in only 5 percent, a 7-1/2 year low, and U.S. jobless claims have spent 40 weeks below 300,000, the longest such stretch since the early 1970s.

The Fed's latest "beige book" report cited, "Cleveland said that wage pressures were widespread, especially for higher-skilled jobs, while Atlanta reported signs of emerging pressure to raise starting wages, even among low-skilled jobs. The Atlanta and San Francisco Districts said some companies were revising incentives and benefit programs to retain and attract talent." This suggests rising wage pressures are ahead.

Through November, average hourly earnings are up 2.3 percent year-over-year and trending higher. With unemployment hovering near full employment, wage growth could soon be in the 2.5 percent to 3 percent range. In addition, a strong housing market could also push CPI higher. The combination of rising wages and housing costs means the Fed may have to move faster than markets now anticipate. Any bottoming, or even a bounce in battered commodities prices will only add urgency to the situation.

The good news is that we're not about to have a crazy 1970s-style inflation cycle. Markets expect inflation to run at 1.5 percent in the coming year (below the Fed's target of 2 percent) while I expect we could see price rises of about 2.5 percent. That means interest rates are already too low and the Fed is already too slow. Indeed, the Fed's insistence that it will raise rates slowly conflicts with its message that it will also be data dependent.

Now that the Fed is in tightening mode, we can expect much uncertainty in markets in the coming months. Investors will pay close attention to inflation data, jobs numbers and any signs of wage inflation, leading to inevitable volatility and endless debate.

So, what should investors do to protect themselves from rising interest rates?

Markets enjoyed outsized returns in recent years, bolstered by an unprecedented stretch of low interest rates and quantitative easing. But the lackluster returns seen this year will likely persist in 2016. The year ahead is a time for capital preservation until the interest-rate outlook clarifies.

Fixed-income investors should remain short duration and seek yield in such shorter-dated maturities. When yields on 10-year and longer-dated bonds increase substantially, it will be a signal to increase portfolio duration and allocations to U.S. Treasurys.

That's the strategy of our First Western Fixed Income fund (FWFIX), our core fixed-income mutual fund, and in our First Western Short Duration Bond Fund (FWSBX), where we are short duration and overweight corporate bonds and non-agency residential mortgage-backed securities.

In an environment with a significant amount of interest-rate uncertainty, plenty of factors can move markets quickly — a policy surprise, rising commodity prices, geopolitical tensions — making capital preservation of paramount importance. The good news for fixed-income investors is that rates are rising for the right reasons — the consumer is strong and working, and corporate profits (with the exception of energy and metals & mining) are healthy. As rates rise, homeowners will have less opportunity to refinance mortgages. That reduces prepayments and makes well-structured mortgage-backed securities more attractive to investors.

It's a long road ahead and there will be plenty of domestic economic news to digest, as well as the potential for destabilizing events from overseas. The trajectory for the U.S. economy should continue to be upward with employment, housing, and consumer spending helping to maintain modest growth. Wage growth, health-care costs, and higher implied rents will put upward pressure on prices, but lower commodity prices and a stronger dollar will limit inflation.

In a speech in March, Yellen foreshadowed second-guessing about her first move, stressing that her subsequent actions were perhaps more crucial. "More important than the timing of the Committee's initial policy move will be the strategy the committee deploys in adjusting the federal-funds rate over time, in response to economic developments," she said.

In the end, success or failure is not determined by one policy fumble. That means the Fed can still redeem itself. Though many investors are fed up after early miscues, it's not too late to restore confidence and credibility, especially by setting out a clear decision-making framework, effectively explaining decisions and properly guiding market expectations.

Commentary by Barry Julien, president and chief investment officer, fixed income, for First Western Capital Management.