2nd Quarter Client Note – Fed Up With Rising Rates

By Steven Smith | Investment Management

Jul 11

The S & P 500 (total return) Index bounced back from its first quarter (.75%) loss, rising 3.43% in the second quarter. But US stocks were the lone wolf; with virtually all other major asset classes falling. The MSCI World (ex USA) Index fell 2.61%, while the MSCI Emerging Markets Index dropped 7.96%. After being the worst performer in the first quarter (-7.43%) real estate was the second quarter’s best performing asset class, with the Dow Jones US Select REIT Index gaining 9.99%. Go figure.

Tapping the Brakes

The Great Recession of 2008 placed the Federal Reserve on emergency footing; reducing short-term interest rates (the federal funds rate) to near zero and keeping them there for nearly a decade in order to stimulate the economy. The federal funds rate is the interest rate at which banks lend funds to each other on an overnight basis. It is one of the few rates of interest the Federal Reserve directly controls, but serves as a benchmark for other short term rates throughout the economy and only tangentially affects intermediate and long term rates.

With significant improvement in the economy, the Fed began raising the funds rate in 2015 with a .25% increase; followed by another .25% in 2016 and three such increases in 2017. During this period the inflation rate has remained under, but is approaching, the Fed’s target of 2%. A growing economy can raise the specter of inflation. So the Fed is now faced, head on, with managing its dual mandate of fostering maximum employment while maintaining price stability.

After maintaining interest rates in May of this year, the Federal Reserve raised the Fed Funds rate in June by .25%, bringing that benchmark up to 2%, its highest level since 2008. The Fed also indicated that two more increases are likely by year end.

Rising Rates, Falling Bonds

The yield on the benchmark 10-year US Treasury Note ended the quarter at 2.9%, considerably above its 2.5% starting level for the year. The Barclays US Aggregate Bond Index lost a modest .16% in the quarter, compared with the more significant drop of 1.46% in the first quarter.

For investors, rising interest rates are a double edged sword. In the short term, bond prices and bond portfolios fall in value; more so for bonds of longer maturities than shorter or intermediate maturities. But over time, the higher coupons will both cause values to recover and generate more cash flow from the bond component of your portfolio.

Fixing Your Fixed Income

It is as difficult to time the bond market as it is the stock market. So the best strategy is to maintain your fixed income exposure, philosophically, in a manner similar to your equity exposure – consistent with your long term goals and your time horizon. First, make sure that the total amount of bonds in your portfolio – relative to the amount of equities – provides just the right amount of ballast to balance your need for returns and the level of risk you want to take. Second, don’t get fancy with your bond allocations. We recommend high-quality, short-to-intermediate bond funds with low management expenses.

With the past three years of rate increases, some of the damage has already been done; and bonds have still managed to eke out a modest positive return. And it’s by no means clear that interest rates will catapult past “normal” as they did in the 1970’s amid the runaway inflation of that era. We are in year nine of the current economic expansion, among the longest in US history. So the Fed could be challenged to reverse course at any time, with rates actually falling.

Tune Out the Noise

As with every investment quarter, this one was punctuated with jarring news stories; from rising interest rates to trade wars to nuclear summits. All with the potential to knock us out of our investment seats.

But by having and maintaining an enduring investment philosophy and strategy to match your own personal circumstances – understanding how markets work and placing past events in long term perspective – you will be able to tune out the noise that might otherwise cause you to act in an inadvisable manner. At the end of their Quarterly Market Review our friends at Dimensional Funds Advisors boil this down to a neat little formula for success: E + R = O (Event + Response = Outcome.) Very rarely will these events, which are entirely out of your control, matter. Rather, what matters will be your reactions to them. Check it out.

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