Will The Federal Reserve Start Raising Interest Rates?

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2015 has been a roller coaster ride so far.

The stock market was down in January, up in February, and is now trending back down again in March.

Long term bond prices (US 20-year treasuries) were up 10% in January, and then drifted back down again.

And then there was today, Friday March 6th 2015, where the entire investment landscape was awash in a sea of red. It’s unusual to see all asset classes decline at the same time.

Usually, at least stocks and bonds move in opposite directions. But today everything was down – US and International stocks and bonds, real estate, energy, precious metals, you name it.

The only things up were the US Dollar, which is currently enjoying decade highs against other currencies.  And interest rates.

The yield on the 10-year treasury bond jumped from 2.1% to 2.25%, on the news of better-than-expected employment numbers.

This is likely what contributed to the major sell-off in the market today.

This may sound contradictory – better employment numbers means the economy is improving. And an improving economy should be better for the stock market, right? Unfortunately not. There’s no correlation between GDP growth and investment returns.

Investors are worried that an improving economy means the Federal Reserve will start increasing interest rates. Higher interest rates hurt businesses, and could kill the nascent recovery in the housing markets.

It’s also interesting that a lot of publicly-traded companies are issuing debt at historically low prices and using that money to buy back their stock. Companies like IBM and Apple are borrowing money at less than 3%, and instead of using that money to grow their business, they’re opting to reduce the number of shares. This acts to make each share more valuable. (Consider cutting a pizza into 4 slices instead of 8  – each slice is bigger, and thus more valuable). This phenomena has been driving a lot of the growth in the stock market, which is why large companies have outperformed smaller companies over the past few years. (Larger, more established companies can borrow money more easily and cheaply than smaller companies).

Higher interest rates could put the brakes on the bull market in stocks that has been going on for the past six years. And that’s what caused a lot of worry in the markets today.

So should we worry about rising interest rates?

I don’t think so. At least not yet.

Even if the US economy is improving, there is no inflation on the horizon. The Federal Reserve uses rate increases to help curb inflation. But seeing as there isn’t any, the Fed will be hesitant to raise rates too high or too fast.

Even if the Federal Reserve does increase the short-term rates they can’t impact long-term rates, which are set by market forces. And market forces are unlikely to let long-term rates rise any time soon.

While we’re seeing positive economic growth at home, globally, the picture looks a lot more glum.

Europe is in shambles with a recession, high unemployment, over-leveraged countries, and fears of deflation. Commodity-driven economies like Canada and Australia have been hurt by the sharp decline in oil and metal prices.  Even China, which used to be the growth engine of the world, is seeing a slowdown in its economy. And then there’s conflict in Ukraine and Russia.

To help counter this declining economic picture, 17 central banks have cut  interest rates this year.

Europe is trying so hard to stimulate economic growth, banks are paying people to borrow money! (Source: New York Times)

And already 16% of global government debt has negative yields. Yes, the yield on bonds of Germany, Switzerland, France, Belgium, Denmark, Finland, Sweden, Austria and the Netherlands is less than zero.

You give the government your hard-earned money and after a certain amount of time, you get less money back.

Not only governments, but even global food giant Nestle was able to issue short-term bonds last month with a negative yield.

If this wasn’t bad enough, the European Central Bank just initiated a trillion-Euro quantitative easing program. Injecting this kind of money in to the economy will further devalue the Euro and ensure that interest rates on European government bonds stay negative. 

There is an awful lot of money sloshing around, and it needs to find a home.

I’ll bet that a lot of it ends up in US treasuries. When US 10-year bond yields 2% more than German 10-year bond, that’s an easy bet to make. (Surprisingly,even countries like Portugal and Spain whose bonds are rating as “junk”, have lower interest rates than the US! Usually, when you lend money to subprime borrowers, you charge them a higher interest rate).

This demand for US treasuries will prop up bond prices and continue to keep the yield low. And until things turn around globally, I doubt we’re going to see an increase in the yield on long-term debt.

And wealthy foreigners, who are facing the prospect of negative yields in their devaluing home currency, may instead choose to park their cash US real estate instead.

So I’d say there is a chance the real estate boom might continue for a little bit longer.

And compared to the guaranteed loss of purchasing power with negative-yielding bonds, gold is starting to look like a high-yield investment! Maybe, 2015 will see a change in the sentiment towards gold as well.

Does this mean it’s smooth sailing for the stock market?

Not necessarily.

The current bull market in US stocks is getting long in the tooth. It’s been six years since we’ve seen a major correction. So it wouldn’t be unreasonable to see a 20% correction within the next year or year-and-a-half.

A correction isn’t something to be feared. It gives the market time to digest its gains, and for investors to buy in at a cheaper price.

Even if you’re fully invested, you shouldn’t panic and bail in anticipation of a bear market. More money has been lost in anticipation of a correction than in actual corrections.

Besides, foreign developed and emerging markets have been lagging the US stock market for the past few years and are between 20% and 30% cheaper from a valuation standpoint. It’s about time they played catch-up.

So, as I often like to point out, maintaining a globally-diversified portfolio will prove to best the best course of action.

However, I think the major beneficiary of this situation will be intermediate-term Municipal Bonds.

Most investors overlook Munies, which this is a mistake, especially for high earners.

If you’re in a high tax bracket you might be able to pick up bonds with an 7.5% tax-equivalent yield. That’s a great opportunity in this low-interest rate environment.

 

 

 

 

 

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