Understanding Interest Rates and the Fed, Part 2

During the Financial Crisis of 2008-2009, the Fed cut interest rates to drive liquidity and stimulate the economy. The Fed Funds rate was cut to nearly zero. They could not go any lower. When the Fed needed to stimulate the economy further, they were out of their traditional bullets. So, they instituted another tool in the form of Quantative Easing. This was a program where they went into the open market and bought bonds, first Treasuries and then, eventually Mortgage Backed Securities. Again this program was intended to create greater liquidity in the marketplace, which helps the economy grow.

In the past few years, our economy has stabilized and the need for such immense measures has subsided. The Fed has cut back on the bond buying and more recently there has been discussion about the direction of the Fed Funds Rate.

With so much media attention to this issue, I often get asked by clients, “Is the Fed going to raise rates? When? What should we do about it?” I thought I’d share some of my thoughts on these questions in a blog post.

“What’s going to happen?”

The simplest answer is that I don’t know. Nobody does. Janet Yellen doesn’t know. I have an opinion. I think it’s an educated opinion. I think that while the economy has stabilized, we haven’t seen tremendous job growth and therefore haven’t seen any rampant economic growth over the past 7 years. So, inflation has been under control. Interest rates in most of the developed world are ultra-low. We’ve been seeing the dollar gain strength in the international currency markets. While this sounds good, and is good for the imported products that we buy, it can have a very negative effect on our ability to export our goods and services around the globe. If we rush to raise interest rates, foreign investors seeking yield and safety will flock to the US markets which will cause further strengthening of the dollar. Mainly because of these items, I don’t think the Fed is in a position currently or in the near future to raise rates. In the long-term future, I’d expect that rates will go up, but I don’t know when. Rates really have no place to go but up, but there’s nothing that I see today that says they’ll be going anywhere too soon. Disclaimer: I can be wrong, I have been at times in the past. My wife tells me I’m wrong all the time. Not about interest rates but…

“How does it affect me?”

As you may be aware, if rates in the bond market go up, the market value of the bonds that already exist will go down. There can be other factors that play into the value of the bonds in your portfolio, such as credit quality and supply/demand to name a couple. Bond traders, bankers, and investors will all look at the Fed Funds Rate as a benchmark rate in determining rates in their universe. As an investor, it may be important to understand what’s going on with the Fed, but the Fed does not directly control or manipulate the value or rate of anything in your portfolio.

“What should I do?”

I preach often about the importance of asset allocation and maintaining a long-term approach with investments. Much of the time, I think it can be beneficial to filter out much of the noise in the media. Making dramatic changes to your portfolio strategy based on the story du jour can be much of the reason there is such a difference between average investor returns and investment market returns over the long term. This is not to suggest that we all just bury our heads in the sand and let the chips fall where they may. Rather, I think it’s worth looking at, thinking about, and possibly making some minor changes to prepare for the possibility of a higher interest rate environment. But we first need to look at your situations individually and devise any possible changes according to your needs. There is not a single answer for this concern, or any other for that matter.

Let’s talk

I do not make a practice of delivering investment advice to the masses over the internet. Rather, I provide my clients with individualized advice based on their needs. Whether you’re an existing client, a friend, or someone that I’ve not had the pleasure of meeting, I’d suggest that if you have concerns about how you will be affected by the direction interest rates that you get in touch with me so that we can discuss your circumstances indiviually.

In this case, as with most others, I don’t know what tomorrow will bring exactly. Too often we try to predict the future, when many of the solutions for the future can be found by looking at the past and using what we’ve experienced before to guide us to a sensible solution for the future. What we know from the past is that if we approach investing with a long-term approach and build a portfolio that can withstand the stresses that short-term trends can present, and stick with the discipline, we will likely be successful investors.