I know Fed Chairman Ben Bernanke just announced that interest rates will have to stay low to help the recovery, in particular, high unemployment. And he'll do his best to keep rates low. But the truth is that rates are hitting levels not seen since 1940 and to fully illustrate where we are in the current interest rate cycle, you need to see this graph (observationsandnotes.blogspot.com/2010/11/100-years-of-interest-rate-history.html) I would have simply showed the chart but the program here doesn't allow for it. You don't even have to know what the graph represents to see that we're at the bottom of something. That something is interest rates, no matter what the Fed does. The only question is: when do rates start up?
As an investor, you have to be aware of where interest rates are going. They exert more influence on stocks and bonds than anything else. As rates rise, it signals the economy is recovering, businesses borrow more to fund more projects, demand for goods and services increases. There's a period during the nascent stages of a recovery when higher interest rates are seen as a positive. They signal economic activity is picking up. That's good for stocks.
But bonds get hit right away when rates start upward. That's because investors demand higher returns for their dollars. Any existing bonds have to adjust (meaning prices go down) to reflect new rates. Investors with a diverse portfolio of stocks and bonds will want to keep their maturities short now, even though rates are dismally low (the 2 year auction this week sold out at .34%). The pay off is that while investors receive lower returns currently, they have cash to invest in longer maturities when rates go higher. Based on the graphs below, that most likely won't be a long wait.
As for stocks, when rates go higher, it affects their prices because the theoretical pricing model states that the present value of all future earnings, discounted with the current interest rate, gives us the price of a stock. When rates rise, the current rate used makes those future earnings less valuable, and therefore pushes prices lower. But the saving grace for stocks is that earnings will usually outpace the rise in rates and prices go higher. For a while. As soon as earnings can't keep pace with interest rates, the price of stocks goes lower. That period can last a long time if the economy is really booming, and earnings are soaring. At some point, that stops, as does economic expansion.
Timing all these events is impossible. But investors need to be aware of the consequences of higher rates and adjust their portfolios accordingly, especially on the bond portion. There is usually a "grace" period for stocks, as long as earnings do well. Eventually, though, the normal economic cycle will replay, and expansion comes to its natural end, rates reach a peak, and the downturn starts. It's part of our economy. Just know that right now, one part of the economy, interest rates, is about to turn. Don't know exactly when, but it will come. And most likely sooner rather than later.
- Ted Allrich
March 27, 2012