How Will Higher Rates Impact Your Investments?

Last week during her Congressional testimony before the House, Fed Chair Janet Yellen did a good job of expressing the Central Bank’s view that interest rates needed to rise eventually and she did so without jarring the markets. Since the financial crisis of 2008 and 09 the Federal Reserve has pulled out all the stops to keep the US economy moving ahead. The last and most controversial phases of their policy were labeled QE1, 2, and 3, short for Quantitative Easing.

As a tool in the Fed’s arsenal QE has been used before to stimulate the economy, but never in such large measure or for as long. The Fed and markets find themselves in uncharted waters as how to reverse it – hence the need for caution. Move too fast and risk crashing the markets and stalling the economy. Move too slowly and risk allowing too much money in the system to drive up prices, causing inflation.

Quantitative Easing QE (currently in its third phase) is a huge-scale buying of US Treasuries designed to pump (some say ‘print’) billions of dollars into the economy. Ideally, those new dollars stimulate spending on the part of consumers and investing in plant, research, and hiring on the part of companies. It is intended to break the cycle of ‘hoarding’ that typically accompanies economic crises and lengthy recessions.

As the Fed buys Treasuries, supply in market circulation declines. When a thing becomes scarce, its value or price rises. A feature of bonds is that as prices rise, interest rates decline. The second intended consequence of QE1-3 has been to drive interest rates down to near zero. A return of near zero drives savers into riskier assets like stocks. This fact explains the dramatic recovery in the stock market despite the lackluster economic and jobs growth. The intention is that higher stock prices raise the confidence of business managers to spend and invest more, creating more jobs which would stimulate overall economic spending.

Lower rates also forced banks to look beyond their zero-risk returns of 1-2% gained by borrowing from the Fed at near zero to buy Treasuries yielding 1-2% more. To maintain profitability they were compelled to get back into the business of their charters – lending money to qualified borrowers. Again, the intent was that given increased access to capital, businesses would be more more inclined to invest and hire. The effectiveness of QE1 – 3 can be debated, but our purpose today is to explore what to expect as the Fed unwinds from its unprecedented stimulative policy.

How will higher rates impact our portfolios?

US Treasuries are core to our investment policy – every client owns some portion. To explain why, a brief overview is helpful. Three things can be controlled in the investment process, expenses, taxes, and market under-performance. Simplicity is key to efficient investing – the more moving parts, the higher the expenses, taxes, and likelihood that you will under-perform markets. Complexity is not a requirement for wealth creation.

The industry has taught people that bonds in general and Treasuries specifically are a good and safe way to generate income. In fact, neither bonds nor Treasuries are good investments for producing income, now or later in life. Here’s why.

When you buy a bond, at any maturity, you essentially agree to accept a market rate of return (interest) over the life of that bond that is determined by what markets expect inflation will be over the life of that bond as well as the odds of getting repaid on maturity. Since its almost certain that the Treasury will pay you back, your only risk is with inflation. That’s why Treasury rates are lower than other bonds (corporate and municipal). They compensate you only for the erosion of your spending power until you get the bulk of your money back at maturity. Does that sound like a good income-generating investment?

We believe the best way to generate income both now and in the future rests on the stock side of the capital markets. Dividends and appreciation generally grow faster than inflation, providing for lifestyle and spending improvement, not erosion, over time. But what about lifestyle today? Whether you are spending from your portfolio now or saving for future spending you are no doubt not impervious to the volatility of stocks. We address stock volatility in two significant ways.

First, we significantly dampen the risk of individual companies or industries by being globally diversified. We own virtually all of the world’s companies that matter with two exchange traded funds; the Total US Stock Market (VTI), and the FTSE All World Index (VEU). We achieve extreme diversification of more than 9,000 global companies, far more than most. Samsung’s loss is very often Apple’s gain. The obsolescence of one company’s is always at the hands of another. If you own both, the impact is nullified.

Second, common stocks can be very volatile in the short run as emotions can run away even with professionals during crises that may take days or weeks to understand. During these times no asset class on the planet has performed better in the last 60 years when stock market panics occur than US Treasuries. Put simply, people run to Treasuries more often and in greater size than gold, real estate, commodities, or any other ‘alternative’ asset class. Hedge funds are the latest casualty in that mix.

We use Treasuries in our models not for their investment or income appeal, but quite simply for their insurance value. When the world seems to be coming apart and stocks are falling with no end in sight, Treasuries almost invariably rise in value. They act like your car’s shock absorbers on a bumpy road, smoothing out the ride. In 2008 when the S&P 500 fell 38% our 7-10 Year Index of US Treasuries (IEF) was up 16%. Our two most conservative portfolios with 30% stock and 45% stock were down 3% and 6% respectively – a far cry from 38%.

When the Fed begins raising rates stocks will be initially impacted, but will recover if markets believe the economy can withstand the increased price of money. Treasuries will also be undoubtedly impacted negatively, but not nearly as much as some rather recklessly claim. We have demonstrated in earlier Briefs (listed below) what has happened to 7-10 yr Treasuries during periods of dramatic rate increases of the size that would likely never be instituted by a Central Bank charged with maintaining the stability of markets and the economy.

Our portfolios are designed to weather all kinds of economic storms. US history contains at least three periods of hyper-inflation which drove interest rates well into double digits. All the while, the 7-10 year index never lost more than 9.5% in a 12-month period nor has it had back-to-back declines.

All insurance costs money and the best policies can be quite expensive. We believe the US Treasury affords our clients not only the best equity-risk insurance available, but also at far cheaper prices than the alternatives. Treasury interest acts like the dividend check you get from a mutual insurance company, which is a nice offset to the cost of the premium.

Any declines in Treasury prices will be eventually partially or completely offset by the steady payment of interest as well as their approaching maturity. And as rates rise, bonds falling out of the index (fixed at 7-10 years) will be replaced with higher yielding ones.

Previous Briefs providing more detail for Treasury behavior during extreme interest rate spikes:

It’s OK for Treasuries to Decline
Treasuries Remain the Best Hedge Against Equity Risk (studies below the heading But That Was Then, What About Now?)
Why Do We Own Treasuries and Why Do Ships Sink?