By Steve Economopoulos, CFP, ChFC, CMT
One of the main factors impacting the current market, an omnipotent issue, is the role of the Federal Reserve Bank (the Fed) and how it influences the movement of the stock market. There is a relationship between what the Fed does to the discount rate, and how it impacts bond prices and borrowing costs for borrowers. This will affect the overall market - equities, bonds, currency and more - and cause implications for the future direction of portfolio values.
Borrowing at higher rates hurts home buying and purchases that require loans. This could have an impact on the growth of the economy as less may be borrowed by investors. How will these increases impact those who have invested in stocks and bonds? (For more, read: How Interest Rates Affect The U.S. Markets.)
The Impact of Rising Rates
The current and anticipated level of interest rates in our economy provides the basis from which investors can make decisions about what to do with their money. There is a “trade off” between investing funds into equity, fixed-income investments, or cash. If interest rates are on the rise, investors may begin to move from bonds (fixed-income investment prices may fall as investors sell their bonds and look to hold the money to invest in higher rates in the future).
Initially, fearful investors also may sell equity investments due to fear or the desire to move certain stock investments into the potential for higher paying fixed-income investments (due to the rising rates). All of this, as you read, throws decisions into a state of flux and can cause volatility. The important result is for investors to look past this and understand how the rising rates may impact longer-term decisions they may need to make with their money.
The Impact of Prior Rate Hikes
The Fed does not directly change the interest rate of the 10-year Treasury bond (which is plotted over the 24 months on the chart beginning February 2014). The rate over those two years had declined as noted by the blue line moving lower from top left to bottom right. The arrow, shown in December 2015, shows the point at which the Fed raised the short-term discount rate by 25 basis points (0.25 %). (For more from this author, see: Understanding Support and Resistance Levels.)
The question is why did the rate on the 10 year drop from this point? If short-term rates (what you might expect to get on a checking or savings account) went higher, why did the 10 year go lower? In this case, the market was fearful that our economy was not ready for a rate increase. This is what the stock market continues to debate today. At some point, the downtrend we have witnessed in rates will become a more permanent uptrend. When this takes place, evaluating all portfolio holdings is a must.
Understanding the Fed's Main Goals
First, it is important to understand the main goals of the Fed. They focus in three areas in order to support the growth of our economy: full employment, stable inflation, and financial stability. An increase in rates is intended to slow down growth, although initially it can spur on demand and/or increase fear. An economy growing too fast can cause issues just as an economy that is not growing (or falling, known as a recession).
The initial shock of an increase often causes a confused and volatile market. This is what we have seen since the December 2015 rate increase (the first rate increase in over nine years). Short-term rate increases could eventually lead to a rise in longer-term rates. This assumes economic growth does not slow too fast due to the rate increase. This is what investors fear as rates rise.
3 Steps and a Stumble
There is a well-known principle that we believe has held true in the past called “three steps and a stumble.” It suggests that stock and bond prices will fall after the third rate increase by the Fed. Thus, it is worth noting that while rates may begin to rise, the pace and amount by which they are expected to rise after the first few increases is possibly more important than the first increase. Given time, these could slow growth enough to impact the stock market. And with that, you could see a change in the expected return in the portfolio you hold. So the lesson with Fed rate increases is summarized with the following - don’t fear the fed – be diligent and use the opportunity to your advantage. (For more from this author, see: Selling a Stock: When Is the Right Time?)
Disclosure: Past performance may not be indicative of future results. No current or prospective client should assume that the future performance of any specific investment, investment strategy (including investments and/or investment strategies recommended by the adviser), will be equal to past performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will l either be suitable or profitable for a client's investment portfolio. The information presented herein is intended for educational purposes only, and is in no way intended to be interpreted as investment advice. In considering the information presented, readers should consult their own professional advisers, as there is no substitute for personalized investment or tax advice. Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Econ Wealth Management LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.” The CBOE 10-Year Treasury Yield Index is based on 10 times the yield-to-maturity on the most recently auctioned 10-year Treasury note. These notes are usually auctioned every three months.
This article was originally published on Investopedia.