The immediate reaction after last week’s Federal Open Market Committee announcement: panic. Stocks, bonds and gold all sold off. The rationale for the sell-off was that, at long last, interest rates could finally head higher over the next year. With 13 out of 15 FOMC participants now forecasting the first increase in the federal funds rate occurring in 2015, there is indeed a higher-rate consensus within the Federal Reserve. The Federal Reserve also announced the continued reduction in its quantitative easing program and many market participants now expect the program to end by October of this year.
What does this all mean for the average investor?
Before investors attempt to answer that question, some perspective is necessary. The Fed first moved short-term interest rates to zero percent in December 2008. During the same month, they launched the first round of quantitative easing. We are now over five years into zero interest rate policy and on the third iteration of quantitative easing. To say this has been the loosest period of monetary policy in history would be an understatement.
Although this easy monetary policy has certainly lifted U.S. equity prices, the effect on the U.S. economy is less clear. The economic expansion continues at a moderate pace but we have yet to see real wage growth. While the Standard & Poor’s 500 index is hitting new all-time highs, the average American household has not been keeping up with inflation. The low interest rate-policy also has been undeniably harmful for savers and investors reliant on fixed income vehicles, particularly those in their retirement years. It has also forced many of these savers and retirees to move up the risk spectrum, trading a risk-free rate of return for junk bonds and high dividend paying equities.
This is a dangerous game, of course, because there is no free lunch in the markets. With higher risk comes a higher probability of a significant drawdown. Unfortunately, most investors in their early retirement years cannot afford to see a large drawdown in their portfolios. Although the market has rewarded this excessive risk taking thus far, we are likely getting closer to a period of higher volatility.
This brings us back to the question posed above: How should the average investor think about the prospect of higher interest rates? First, investors need to recognize that short-term rates are unlikely to rise for at least another year, and that any economic weakness could push this timeline out even further. But to the extent that the current Fed forecasts are correct, investors should not be surprised to see higher rates next year, especially as at that point it will be over six years of zero percent interest rates.
Rather than fearing rising interest rates, I believe most investors and retirees in particular should be embracing the prospect of higher rates for the following reasons:
1. Higher rates = Higher returns from savings. While the highest Federal Deposit Insurance Corp.-insured savings accounts are yielding only 1 percent today, these rates should finally begin to rise next year if the Fed starts raising the federal funds rate.
2. Higher rates = Higher bond returns. The best predictor of long-term returns from bonds is the beginning yield. With yields still near historic lows, investors cannot count on returns from their bond allocations from here. As rates rise, the prospect for returns will rise as well. To the extent possible, investors should favor investing in a ladder of fixed-maturity bonds over bond funds as a rise in interest rates is likely to have an adverse impact on bond fund returns in the short-run, which we saw last year.
3. Higher rates = A better economy. As noted above, the stock market has far outpaced the broad economy and the average American household. Higher interest rates tend to mean higher economic growth, which hopefully will translate into better employment prospects and an improvement in real wage growth. If, after six years of zero percent interest rates, the Fed finally raises rates next year, it will likely mean that we are finally seeing an improvement in the real economy and not just the stock market.
These would all be positive developments for most savers and investors, but what is the downside of higher rates? In my view, the greatest downside will be experienced by investors who have reached for a higher yield over the past year by taking on more risk than they can handle. If easy monetary policy has disproportionately benefited U.S. equity prices and high yield credit, it stands to reason that the removal of easy money will disproportionately hurt these areas. Investors would be wise to examine their portfolios to ensure that their holdings appropriately reflect their risk tolerance.
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