Why the Fed Shifts Interest Rate Gears
When driving a car, you may only have a vague idea of how the underlying engine mechanism works. Internal combustion engines can contain any number of combustion chambers (cylinders), typically between four and twelve. Yet you should know that the accelerator speeds you up and the breaks slow you down.
When driving a portfolio construction strategy, you may also only have a nominal understanding of the five underlying factors (cylinders) of investment risk including alpha, beta, r-squared, Sharpe ratio and standard deviation. These statistical measures are historical predictors of volatility and are all major components of modern portfolio theory (MPT).
Similar to basic concepts of acceleration and braking, investors should acquire fundamental knowledge of the mechanics of interest rates and how they can affect the economy and their financial life over time.
No matter whether you are from generation -Z and signing up for a college loan, a millennial shopping for a home mortgage, a spendthrift up to your neck in credit card debt or a retiree attempting to “squeeze” investment income out of your nest-egg, most of us at any age are not immune from the movements of interest rates.
A bit opposite of the effects of the accelerator and brakes on your car, when the economy is decelerating the Fed downshifts short term rates (the Fed funds rate) into lower gears to help speed up the economy while encouraging lending and investing. When the economy is accelerating along with inflation, the Fed up-shifts short term rates into higher gears to help slow it down.
While we are a far -cry from the 80’s era of cheesy pop-music, fashion trends, Reaganomics and historically high inflation, long-term rates, bench marked by the 10-year Treasury yield, was as high as 2.8% at the start of the year before falling below 1.5% only two months ago (see below) – the lowest level since 2016. It’s now risen almost half a percent to 1.94%. As a result of this rate volatility, the yield curve also inverted briefly earlier this year.
Interest rates matter to investors for many reasons.
Most obviously, interest rates are directly related to the amount of income investors can expect to generate from their portfolios. As a measure of the “risk-free rate,” the yields on U.S. Treasuries represent a baseline level of interest that can be earned by investors across different maturities. Choosing to take on additional risk allows investors to potentially increase their yield above and beyond this risk-free rate.
Unfortunately for investors with large cash savings – especially those in or near retirement – interest rates have been quite low throughout this business cycle. Since 2012, the 10-year Treasury yield has only surpassed 3% during two short periods before falling back each time (see below). This has made it extremely difficult to generate sufficient income from safer bonds alone.
One reason that interest rates have been so low for so long is that central banks such as the Federal Reserve have kept their policy rates low, and at times have even depressed rates further by buying financial assets. The fact that economy has only been growing at a modest rate, even if it has been doing so steadily for a decade, means that central banks have continued to add stimulus measures. For those who depend on their portfolios and cash savings for income, this has meant taking more risk in order to generate sufficient yield.
But perhaps the more important reason that interest rates matter to investors is that they incorporate information about the economy.
Specifically, the yield curve is a signal of where we are in the business cycle and of recession risk. Typically, the yield curve is very steep at the beginning of a cycle. This is because the Fed keeps short-term interest rates low during economic downturns to stimulate the economy. As growth picks up, long-term rates begin to rise, which steepens the yield curve. Eventually, however, growth slows, or the Fed over-tightens, resulting in a flatter or inverted curve.
From that perspective, interest rates are providing both good news and bad news. The bad news is that rates continue to be low, making it difficult to generate income. The fact that the yield curve had inverted briefly a few months ago – i.e. long-term rates were below short-term ones – is also a classic signal of future recession.
The good news is that long-term interest rates have risen in recent weeks, resulting in a yield curve that is no longer inverted. Short-lived inversions have occurred in the past, including in the late 1990s, often due to global economic shocks. While recessions are an inevitable part of business cycles, a “re-steepening” of the yield curve often suggests there’s more time left in the cycle.
Either way, investors should continue to stay balanced in light of the swings in interest rates this year. Those who need income will continue to find better yields in other parts of the market such as high-yield bonds, preferred stocks, dividend-paying stocks, real estate, utilities, telecom and the like, of which all come with their own duration and sector risks.
All investors may, at least for the near term, benefit from the optimism that rising rates suggest about the world – and the all-time stock market highs that have come along with it.
Below are three charts that put recent interest rate moves in perspective.
1. Interest rates have risen in recent weeks
Interest rates have recovered recently due to optimism around headlines such as U.S.-China trade and the U.S. economy. There are many forces affecting rates at the moment, including low international rates – especially in Europe – and slowing U.S. growth. However, increased investor optimism could push rates up further if there are breakthroughs in global issues.
2. The yield curve is no longer inverted
As a result of both rising long-term rates and recent Fed rate cuts, the yield curve is no longer inverted.
3. Yields on cash are still low
While cash rates have increased, they are still quite low by historical standards. This is especially true after adjusting for inflation – the purchasing power of savers’ wealth continues to be eroded by low interest rates.
The bottom line? Interest rates have been extremely volatile this year. Investors should continue to find other sources of income, maintain a 4% or less income distribution strategy if warranted and stay balanced in their portfolios according to their age, risk tolerance and financial goals.
For more information on our firm or to get in touch with Jon Ulin, CFP®, please call us at (561) 210-7887 or email jon.ulin@ulinwealth.com. Get Started Today.
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The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without Ulin & Co. Wealth Management’s or IFP’s express prior written consent.
