Will a rise in US interest rates cause investments to tumble?
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Version 0 of 1. Tick-tock. Tick-tock. We still don’t know when it’s going to happen, but we do know it’s only a matter of time. I’m referring, of course, to the inevitable day on which Federal Reserve policymakers begin to raise interest rates for the first time since 2008. The next key piece of economic data in the puzzle will arrive first thing Friday morning, when the Labor Department tells us just how many new jobs employers created during the month of May. Economists currently predict that figure will come in at around 225,000 – a pretty healthy number, if not enough to push the unemployment rate down below its current level of 5.4%. All the news points to a rate hike sooner rather than later. When it happens, we’ll all need to brace ourselves: our borrowing costs will start to rise on everything from our credit cards to any new mortgages we take out (or need to refinance), while our fixed income investments will be thrown into turmoil. Fed-watching has become an even more intense pastime in recent weeks. The release of the minutes of the central bank’s last meeting in April gave some fearful folks a bit of relief, appearing to signal that policymakers would wait for definite signs that the economy was strong across the board and not just bumping along unevenly. Then came a speech by Federal Reserve chair Janet Yellen on 22 May that turned all that on its head. Brace yourselves, she warned us. Some of the signs of economic weakness might be no more than “statistical noise”, she said, adding: “I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target.” Some pundits and economists point out that interest rate hikes really aren’t all that terrifying. They’re right, if you judge only by looking at what has happened historically. Yes, it wasn’t much fun back in 1994 – when key lending rates doubled over the course of a year-long “tightening” cycle, as Alan Greenspan’s Fed battled inflationary pressures – if you happened to be trying (as I was) to sell a house. Mortgage rates shot higher; demand collapsed; housing prices plunged. Ouch. But the stock market simply ambled sideways for the better part of a year, before rallying in 1995. The last round of Fed interest rate hikes, between 2004 and 2006, actually was accompanied by a rise in stock prices. Here’s the problem. The last time the Fed raised interest rates – a decade ago – the world was a very, very different place. It isn’t just that we’ve experienced the biggest financial crisis since the Great Depression, or even that many years have passed since we’ve witnessed a rate hike. The changes that have taken place in the way financial markets work in the past decade mean that when the Fed acts this time, it could have very different consequences. For starters, as the notorious “Dr Doom” aka economist Nouriel Roubini points out, we’re in a world where there’s a lot less liquidity. That means when the market gets a shock – and even the mere prospect of the Fed raising rates has delivered a shock to the system – trading shrivels up and vanishes. Liquidity is vital because it takes a toll on prices. In the US Treasury bond market – which is supposed to be one of the most liquid markets in the world – if there’s no one willing to buy your securities, the price simply collapses. That’s even more possible today, because banks have scaled back their “market making” activities that once helped smooth out some of those violent price swings. There’s a good reason for that: regulators don’t want banks loading up their balance sheets with all kinds of risky securities when their primary business isn’t to trade for themselves but to facilitate transactions for others, so they’ve made it more costly and difficult to do so. But those new rules and charges have had some unintended consequences for liquidity. Even without an actual interest rate hike to stress out over, we’ve already seen the impact of reduced levels of liquidity on bond prices, both positive and negative. Last October, for instance, stressed out and fearful investors worldwide poured money into US Treasury bonds, causing traders to shut off their electronic systems and triggering the kind of violent price swing in the $12.3tn market that most pundits say shouldn’t even happen. But what does that mean for you and I? Well, if you’re an investor in bond mutual funds – and most of us are – it means that the value of your investment is likely to swing far more violently as the news flow becomes more jammed with speculation about the timing and magnitude of the Fed’s plans for interest rates. Bond investors are already feeling some of that pain, as big swings between hope that the Fed will hold off on rate hikes – which will eat into the value of existing bonds – and anxiety that they’ll move more rapidly than expected cause market gyrations. Whenever the Fed does act, expect many of your bond funds to feel the pain. There’s an argument that junk bond funds – which invest in securities issued by companies with a below-investment grading rating, that frequently trade as if they were stocks rather than responding to interest rate trends – will fare better than other kinds of bond funds. But junk bonds have been in a multi-year bull market, are trading at premium prices, and face the same kind of liquidity issues that other bonds do. Veteran bond investor Jeff Gundlach, for one, advocates abandoning this asset class the moment that the Fed starts raising rates. At least the Securities and Exchange Commission is waking up to the fact that the financial markets – and most of us, as investors – aren’t well prepared for what lies ahead. In a rare unanimous move, the five Republican and Democratic party commissioners all voted in favor of a rule that would require mutual funds to tell us how vulnerable their holdings are to changes in interest rates – for instance, what would happen to their performance if rates were to rise by one percentage point? The SEC views that move as necessary in part because the bond fund managers, too, have changed the way they operate in the decade or so since the last interest rate hike. They use a lot more derivatives and other kinds of strategies to obtain their exposure to bonds that weren’t quite as mainstream a way to help them boost their returns and try to contain risk as they were a decade ago. And so history isn’t really much guide to how they’ll fare in a new interest rate cycle. The bond market isn’t even waiting for the Fed to act. Earlier this week, the ten-year Treasury bond recorded its largest one-day decline in price (and a corresponding jump in yield, the amount that an investor captures in interest income when the bond’s official interest rate is adjusted to reflect its price) in nearly two years. There will be more of this to come, as strong or stronger economic data rolls in, and as the Fed finally acts and the market accepts that this will simply be the first in what will be a series of interest rate increases. At least one economist who has studied how the stock market works in conjunction with Fed policy suggests that we could face some bumpy times in stocks, as well. Robert Johnson, author of Invest with the Fed, has found that it’s the fact that the Fed is raising rates – rather than the absolute level of interest rates – that is most significant. Over a 50-year period, he found that when the Fed was making less money available (by raising interest rates), the S&P 500 index produced returns of just under 6%, while it earned about 15% when the Fed was cutting rates. None of this means you should yank your cash out of your stock and bond investments and stick it into your bank account or under your mattress. For starters, most of us are likely to be very, very bad when it comes to picking the right moment to get out of the market, or to get back in. That means that we’ll stay too long at the party – and we’ll end up missing up out on a good chunk of the upside whenever things start to improve again. It just means that we need to buckle our seatbelts and prepare for what is likely to be a very bumpy summer. Take a look at your portfolio and make sure you’re comfortable with the level of risk you’re taking. Have you refinanced your mortgage? Have you been meaning to buy a new car? This may be a final chance to lock in some ultra-cheap financing. The same is true of your credit cards. How large a balance are you comfortable carrying if your bank ratchets up the interest rate in the coming months – and do you have a way to pay that down, perhaps by dipping into a fixed-rate line of credit? The coming months won’t be easy. By the time they’re over, we may all feel as if we’ve just staggered away from a “Drop of Doom” ride at a Six Flags theme park – only having paid a lot more for the chills, and without experiencing so many thrills. But they’re part of the price we pay for a prolonged period of ultra-low rates – and the hefty stock market returns those rates have helped to generate since 2009. |