Interesting Interest Rates

Fed Graph

As busy as most of us are with careers, helping our kids (school aged or grown), keeping up with the house and finding time for friends & family, etc. it’s easy to lose perspective.  Specifically, it’s hard to recognize that from a financial perspective, we are living in truly historic times.  Now your eye probably already tracked over to the graph, which shows the history of where “The Fed” holds the Federal Funds Rate which as you can see, has been very, very low for a very long time.  This rate is defined as “interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight”.  In laymen’s terms, this is, for the most part, what people in the financial press are referring to when they discuss the current state of “interest rates”.

I believe we’re living in historic times because it’s easy to contrast the current “Federal Funds Rate” (the last six years) with the prior 60 years.  As you can see, it’s mostly touching the bottom of the graph since 2009!  Compare that to the last 60 years, where there wasn’t a single instance of approaching that level, even though we endured eight other recessions.

Interest Rates Certainly Biased Higher……At Some Point

The point is this:  In a modestly growing economy with little inflation (like today), interest rates are almost certainly going to return to a “normalized” state.  This means they will eventually rise again.  Regrettably, I can’t tell you when that’s going to occur.  And you should also know, nobody else can tell you the timing either – no matter what some “proprietary algorithm” / crystal ball says.

But, instead of bloviating about how higher rates will impact the economy or currencies (things we can’t control) we should really be asking this:  How does this impact things we CAN control?

Everyday Implications for Our Families

In my opinion there are three main areas we should focus on, all of which are “endogenous” factors or things we can control.  They are our equity positions, our fixed income positions and our debt positions.  Let’s take a look at each:

Potential Impact on Equity Investments:  The conventional wisdom is that higher interest rates will mean higher borrowing costs for companies and consumers, which means higher interest expense, lower profits and a lower stock prices.  However, some recent research / reading I’ve done actually refutes this point based on history.  In fact, what’s more important than the fact that rates are rising is the pace at which rates are rising.  In short, fast = bad and slow = good.  According to financial author Bob Brinker, in four of the last five gradual rate-hike environments (1955, 1958, 1963 and 1977) the stock market actually went UP the following 12 months by an average of 18%!  This has less to do with what a rising rate environment and more to do with a strengthening US economy and modest inflation expectations.  So in short, a strong and growing economy trumps modest interest rate increases for a net positive, as long as the pace is moderate.

Potential Impact on Fixed Income Investments:  Similar to equities, the most commonly held belief is that rising rates automatically take down fixed income (bond) investments.  While there is some truth to this, one important nuance to keep in mind is that typically, this negative impact is minor and short lived.  In fact, Vanguard recently published a study showing the total return (interest and principle) of an intermediate term bond fund was actually positive four, seven and ten years after a rate increase.  Again, this assumes the pace of the increases is modest.  In this case, less than four percentage points in a year.  The reason for this is bonds mature and proceeds can be re-invested at higher rates.

Potential Impact on Household Finances:  Rising interest rates can of course impact our own financing decisions for big ticket items.  So any family with outstanding debt should take a look at their rate agreement and see which are fixed and which are variable.  Obviously, this might be a good time to switch out those variable rate loans (mortgage, HELOC, credit card, student loan, etc.) to fixed rates so as to lock in your future cash out flow.  While you may be paying more out-of-pocket near term (fixed rates are usually higher) you might sleep better at night know you don’t have to be a “Fed watcher” along with the rest of the financial world.  If you’re looking to buy a car or a home, this might also be a good time to lock in the fixed rates associated with these purchases.  Again – to emphasize – I don’t know when rates are going to rise.  I just know at some point they will.   And while the “financial returns” might be initially lower for locked-in, fixed rates the “sleep-at-night returns” of knowing your monthly obligations may supersede the financial considerations.

Potential Silver Linings:  Finally, I do see a few silver linings for higher rates.  First, as I alluded to earlier higher interest rates usually mean a stronger economy which is good for job prospects, wages, etc.  Second, higher interest rates also mean those living on fixed income or living on interest payments will actually have more dollars to spend (interest income) assuming inflation isn’t rampant.  Finally, having higher rates does give the Fed some “breathing room” and another tool to help stimulate the economy if/when we do endure another recession, which we will.

Bottom Line:  Based on recent Fed testimony, I believe they will be very cautious and in the absence of inflation today, and I’m guessing they will in fact raise rates at a very slow pace- maybe 0.25% per quarter for the next several years, excluding any global financial shocks.  This may not be as scary a scenario as some may think, as long as the pace of the rate increase is modest.

In short, the tried-and-true axioms of diversification, investing for the long term and “controlling what we control” continue to hold true.  So put down that transcript of the Fed’s press conference and play with the kids, build your career and have some fun with friends.

 

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