By Allyn Hughes, CFP®, ChFC®, CLU®, CAP®
After years of anticipation, the Federal Reserve Open Market Committee (the Fed) appears more certain to begin increasing short-term interest rates within the next few quarters.
This is a great sign because the Fed may finally think that the U.S. economy is strong enough to remove one more prominent form of stimulus.
If a downturn occurred today in the U.S. economy, the Fed would be essentially powerless to provide any real stimulus because interest rates are near zero and monetary policy has been very loose since the 2008 financial crisis. The economic solutions of lower interest rates and government backing of companies (banks) in crisis, would be unavailable.
If interest rates were increased, the Fed would at least be able to lower them as a stimulating measure if declining economic output returned.
Bond performance during periods of increasing interest rates
When interest rates have increased over the past 30 years, more often than not the performance of most bonds has been pretty good during that period.
|Period||Amt. of Hike||U.S. Govt Bonds||U.S. Credit Index*||Muni||High Yield||Em. Market Bonds|
|3/29/88 to 2/24/89||3.25%||3.92%||5.21%||7.44%||N/A||N/A|
|2/4/94 to 2/1/95||3.00%||-2.69%||-3.93%||-3.56%||-1.74%||-21.70%|
|6/30/99 to 5/16/00||1.75%||3.27%||.10%||-.16%||-2.27%||14.92%|
|6/30/04 to 6/29/06||4.25%||5.41%||5.85%||9.30%||14.88%||25.44%|
*Investment-grade taxable corporate and government-related bond markets. Sources: BofA Merrill Lynch U.S. Treasury Master Index; Barclays U.S. Agency Fixed Rate MBS Index; Barclays U.S. Credit Index; Barclays Municipal Index; Barclays U.S. High Yield 1% Issuer Cap Index; JP Morgan EMBI Global Index.
The 1994-95 rate hike (from 3.0% to 6.0%) was universally difficult, especially for emerging market bonds. But different types of bonds responded differently to each rising rate circumstance. There is not a clear precedent for what we’re likely to experience in the next rising-rate cycle.
This time around, rate increases may be very slow and may not go very far. In a webcast June 30, Joe Davis, head of the Global Investment Strategy Group at Vanguard said that he views an interest rate “liftoff” as a positive sign for the economy but that he doesn’t expect the Fed to go far. He forecasts a 1% rise over several increments and then likely a significant pause to re-evaluate. Davis believes long-term interest rates (set by the marketplace) may not move much at all regardless of where the Fed takes short-term rates.
Getting back to the point where your money market fund pays more than your auto loan interest rate may not be in our future (or ever – here’s a good read on the possibility risk-free cash may justifiably pay nothing.) It’s hard to say what the new normal rate environment will be.
When interest rates rise, prices of existing bonds can be impacted negatively. While the magnitude of bond market declines is generally very low relative to stocks, it’s possible that the next rising rate cycle could be among the more harsh to bond returns. There simply isn’t much income available via interest payments to offset price declines.
Rate changes are already built into bond market prices according to Davis.
We have generally chosen to avoid long-term bonds and are lighter than market weight on U.S. government bonds. This means the mutual funds and exchange-traded funds that we use collectively lean more toward corporate, mortgage-backed and foreign bonds.
We trust the managers of these bond funds to gauge interest rate sensitivity along with credit quality. While these bonds may not generate attractive returns relative to the past 30 years, we expect that they will still play a valuable role in risk management, acting as shock absorbers when stocks hit eventual potholes.
~ Brooks, Hughes & Jones Wealth Advisors — Tacoma, WA