The Fed Poked The Bear
Rising interest rates are not always a bad thing. As interest rates move higher, the drop in value can be concerning, but in the longer-term, higher rates mean higher expected returns for investors, as bonds begin to produce more income.
By Senior Advisor Kirk Ludwig, CFIP, AIF®.
March 20th was the celebration of the Vernal Equinox and the Earth’s axis has once again shifted us into a new season. From the green pop of tulips sprouting to the warmth of the sunshine spilling through the windows, the United States began celebrating one of their most beloved seasons: The NCAA March Madness Basketball Tournament, or as many of us like to call it… Spring! Along with spring comes the chirping of migrating birds and the waking of hungry bears. This spring the Fed gave the “bond bear” a bit of a poke to get the season rolling.
After a two-year hibernation of zero percent interest rates, the Fed has embarked on the challenging mission of hiking interest rates to combat elevated inflation levels while not inducing a recession at the same time.[1] By increasing short-term interest rates and reducing the size of their balance sheet, the Fed will attempt to orchestrate a soft economic landing.[1] So how many times will they need to raise interest rates to accomplish their goal?
Now for the bad news “bear”… The Fed indicated their intent to continue raising rates into the near future.[1] As of the end of March, the market is expecting the Fed to raise rates eight to nine more times in 2022.[2] This number has changed multiple times in the past few weeks and will likely continue to adjust in the coming months.[2] As new information is presented to the market, bond yields will quickly reflect the possible changes which may occur as a result.
Why are rising rates viewed negatively by the market? Let’s revisit how bond values can change based on the change of market interest rates. Like a teeter-totter, when rates rise, bond values fall and vice versa. Additionally, the sensitivity of the price change is primarily impacted by the term length (maturity) of the bond. The longer the maturity, the more sensitive the price of the bond will likely be. With this recent move higher in yields, the S&P U.S. Aggregate Bond Market Index dropped 5.57% in the first three months of 2022.[3] One of the worst starts of the year on record.[3]
However, rising rates are not always a bad thing. As interest rates move higher, the drop in value can be concerning, but in the longer-term, higher rates mean higher expected returns for investors, as bonds begin to produce more income. The chart below shows the change in yields for three different time periods; 1.) 09/30/21 - before the Fed indicated their plan on raising rates, 2.) 12/31/21 – early stage of the Fed’s plan, and 3.) 03/31/22 – the market’s interpretation of future rates as of the end of the quarter:[2]
Source: “Daily Treasury Par Yield Curve Rates“. U.S. Department of the Treasury, treasury.gov.
As illustrated in the graph, current interest rates have moved markedly higher since the start of the year. Short-term rates - inside three years - have had the most dramatic move as the market prepares for future rate hikes. The longer maturities, which often provide more information about future growth and inflation expectations, have experienced a parallel shift higher. The shape of the yield curve prices in the future expected events, i.e. rate hikes, inflation, economic growth to name a few.
With all the uncertainties surrounding today’s markets, the day-to-day news can be distracting to investors. If you’re worried about how many more times the Fed is going raise rates, know that the market has already priced in that risk. Future inflation? Same answer. Possibility of future recessions… same! Therefore, trying to make long-term decisions on short-term news can often lead investors down the wrong path.
‘Ok, so what should we do now?’ SJS does not react to the short-term noise, but we do evaluate the longer-term expected risk and return characteristics of each segment of the portfolio and manage to those risks. Some of the adjustments that we have made on behalf of our clients:
Maintaining a shorter duration than the total bond market: We believe this reduces interest rate risk relative to the total broader US bond market, while still maintaining broad diversification.
Investing in shorter-term inflation-protected securities: We believe this hedges the portfolio against sharp increases in inflation, while still maintaining a relatively short duration.
Adding diversified alternative investments: We believe investing in diversified alternatives with low correlation to US stocks and bonds can help to redistribute expected risk, broaden diversification, and increase expected returns compared to US fixed income over the long-term.
While you are enjoying the shift into this new season, be comforted in knowing that SJS is continuously monitoring the market and keeping your best interests top of mind. As markets experience higher levels of uncertainty, the best course of action is to maintain a strong discipline with broad diversification. Yes, the hungry bear may seem scary, and you will likely want to run, but the market will eventually find its balance so we can all get back to monitoring our college basketball brackets.
Important Disclosure Information & Sources:
[1] “Fed Raises Interest Rates for First Time Since 2018“. Nick Timiraos, 17-Mar-2022, wsj.com.
[2] “Daily Treasury Par Yield Curve Rates“. U.S. Department of the Treasury, treasury.gov.
[3] “S&P U.S. Aggregate Bond Index“. S&P Dow Jones Indices, spglobal.com/spdji/en. The S&P U.S. Aggregate Bond Index is designed to measure the performance of publicly issued U.S. dollar denominated investment-grade debt.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
MarketPlus Investing® portfolios consist of institutional quality registered investment companies. Investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Advisory services are provided by SJS Investment Services, a registered investment advisor (RIA) with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains. The performance of the indices was obtained from published sources believed to be reliable but which are not warranted as to accuracy or completeness.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.
Is Your Cash Keeping Up With Inflation?
Cash management remains vital to both risk mitigation and capital preservation. How can you increase your expected return via cash-like holdings?
By SJS Investment Services Chief Investment Officer Tom Kelly, CFA.
The adage “Cash is King” has been used in investing to highlight the value of holding on to cash to both protect an investor from having to withdraw when the markets are down, as well as the ability to deploy cash and purchase when prices become cheaper. However, over the last decade, with interest rates kept low near the anchoring Fed Funds rate, inflation has outpaced the interest rate on cash, leading to that cash losing its spending power over time.[1]
In the US, the erosion of cash value has been greater in recent times than previous periods, with cash trailing inflation since 2009, seen below. We believe this trend is likely to continue, with the Federal Reserve indicating they will continue to keep interest rates near 0%, all the while continuing to provide stimulus to the economy, leading to a 5-Year Breakeven Expected Inflation Rate of 2.35% as of February 23, 2021.[2][3]
Source: Morningstar. Cash represented by the US Treasury T-Bill Secondary Market 3 Month Rates. Inflation represented by the US Bureau of Labor Statistics Consumer Price Index All Urban Seasonally Adjusted Index. See Important Disclosure Information.[4]
Cash management remains vital to both risk mitigation and capital preservation. How can you increase your expected return via cash-like holdings? Online banks sometimes offer higher savings account interest rates than traditional banks due to their lower fixed physical costs. Depending on the holding time horizon, cash alternatives may include Treasury Inflation-Protected Securities (TIPS) or other higher-quality short-term bonds. Furthermore, both real estate and stocks have historically significantly outperformed inflation over the long-term, though they typically add significantly more volatility over the short-term.[5]
Prudent cash management can add incremental value to your overall portfolio investment return. If you have any questions regarding your cash management, please feel free to reach out to us.
Important Disclosure Information And Sources:
[1] “How Inflation Affects Your Savings Account.“ Justin Pritchard, 07-Jan-2021, thebalance.com.
[2] “Powell Pledges to Maintain Fed’s Easy-Money Policies Until Economy Recovers.” Paul Kiernan, 24-Feb-2021, wsj.com.
[3] “5-Year Breakeven Inflation Rate.” Federal Reserve Bank of St. Louis, 23-Feb-2021, fred.stlouis.org. The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 5 years, on average. See Important Disclosure Information.
[4] The US Treasury T-Bill Secondary Market 3 Month Rates are the daily secondary market quotation on the most recently auctioned Treasury Bills for the 13 week maturity for which Treasury currently issues new Bills. Market quotations are obtained at approximately 3:30 PM each business day by the Federal Reserve Bank of New York. The rate at which a Bill is quoted in the secondary market and is based on the par value, amount of the discount and a 360-day year.
The US Bureau of Labor Statistics Consumer Price Index All Urban Seasonally Adjusted is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88 percent of the total population, accounting for wage earners, clerical workers, technical workers, self-employed, short-term workers, unemployed, retirees, and those not in the labor force.)
[5] Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies. Jeremy Siegel, 2014, McGraw-Hill Education.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Advisory services are provided by SJS Investment Services, a registered investment advisor with the SEC. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only.
Statements contained in this post that are not statements of historical fact are intended to be and are forward looking statements. Forward looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.
Suggested Reading
How Will Inflation Impact Your Portfolio?
Since expected U.S. inflation is now near the long-term target of 2.00%, we think it is reasonable to expect that interest rates will remain near current levels.
History and Signaling Suggest Both Inflation and Interest Rates Will Remain Low
By SJS Investment Associate Bobby Adusumilli.
The Federal Reserve of the United States of America (the Fed) has a dual mandate: to maximize employment and to stabilize prices for goods and services. To pursue this mandate, the Fed believes that a 2.00% increase in annual inflation is most appropriate in the long run.[1]
While the Fed cannot completely control inflation, the Fed influences inflation by setting a target Federal Funds Rate (the rate at which banks borrow money from the government) and more directly changing the amount of money circulating in the economy in order to push the current Federal Funds Rate to the desired rate.[1] Consequently, while the Fed doesn’t directly control most other interest rates, shorter-term interest rates (< 1 year) generally follow changes in the Federal Funds Rate, and longer-term interest rates (>= 10 years) tend to follow as well (though with more variability).[2]
Source: “A Look at the Fed’s Dual Mandate.” Federal Reserve Bank of St. Louis, 08-Aug-2018, stlouisfed.org.
When inflation is higher (lower) than the Fed targets, the Fed will typically aim to decrease (increase) the money supply in the economy, which consequently typically increases (decreases) both the Fed Funds Rate and other interest rates, with the goal for individuals to spend less (more) and save more (less).[1]
As of September 30, 2020, the Fed projects inflation to average 1.79% over the next five years, close to the long-run target of 2.00%.[1][3] As illustrated in the graph below, the Fed has worked over the past 50+ years to influence (primarily to decrease) inflation to that 2.00% goal, significantly through affecting interest rates.
Sources: Morningstar, FRED, as of 30-Sep-2020. Interest Rates: 3-Month Treasury Bill: Secondary Market Rate (TB3MS); Inflation: Consumer Price Index for All Urban Consumers: All Items in U.S. City Average (CPIAUCSL).
Generally (all else equal), as interest rates decrease, prices of existing bonds increase, partially because of increased investor demand for higher-yielding investments. Much of the strong returns for US bonds over the past 40 years is due to positive price changes caused by generally declining interest rates.[4]
However, since expected inflation is now near the long-term target, we think it is reasonable to expect that interest payments, not price changes, will drive the majority of positive bond returns over the next 10+ years, and that interest rates will remain near current levels. This provides significant justification for why SJS projects a 2.50 – 3.50% return for US aggregate bonds over the next 10+ years (as further detailed in the SJS 2020 Capital Market Expectations). Using these return expectations as part of the MarketPlus Investing approach allows SJS to help clients develop portfolios designed to meet their current and future needs.
If you would like to talk about how inflation and interest rates may impact your lifestyle and investment portfolio, please reach out to us. We are always here to listen and assist.
Important Disclosure Information and Sources
[1] “How does the Federal Reserve affect inflation and employment?“ The Federal Reserve, federalreserve.gov.
[2] “Monetary Policy Actions and Long-Term Interest Rates.“ V. Vance Roley and Gordon H. Sellon, Jr., Q4 1995, kansascityfed.org.
[3] “5-Year Forward Inflation Expectation Rate.“ Federal Reserve Bank of St. Louis, 30-Sep-2020, fred.stlouisfed.org.
[4] “An Appreciation for the Bull Market in Long-Term Bonds.“ Ben Carlson, 16-Aug-2019, awealthofcommonsense.com.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this report that are not statements of historical fact are intended to be and are forward looking statements. Forward looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.