It finally happened. Yesterday, the Federal Reserve Board made the long-anticipated decision to raise the federal funds rate by one quarter of one percent (0.25%). This is the rate that banks charge one another for overnight loans, and as such, it does not necessarily translate to immediate rate increases elsewhere in the marketplace. However, the interest rate that borrowers pay on many types of loans is often tied to the federal funds rate. So it is reasonable to expect that the interest on mortgages, auto loans and other forms of consumer borrowing will likely increase as well.
In the financial markets, it is important to remember that the Fed does not have the power to control interest rates for financial products. The rate an investor earns on treasury, municipal, corporate and other financial securities is determined by the supply and demand forces of the market. While an increase in these rates may not be automatic, it is reasonable to expect rates to rise over time.
Eventually, client portfolios will benefit from these higher rates available in the marketplace. After enduring low interest rates for years, investors will eventually earn more interest, just as borrowers will start paying more in the future.
HOW DOES THIS AFFECT MY PORTFOLIO?
Along the way to higher bond yields, there is a dark side to higher rates. Most clients have heard us say for some time that return expectations for the fixed income (or bond) portion of our clients’ portfolios should be tempered going forward. While fixed income investments have generally provided strong returns over the last several decades, such returns have coincided with a downward trend in interest rates. All else being equal, when interest rates decrease, bond prices increase, which has served to boost returns. The converse, of course, is also true; when interest rates increase, the value of a bond decreases. So with the likelihood of further rate increases on the horizon, it is our belief that the next 35 years cannot produce the same kinds of returns in the bond markets as the last 35.
Most, including us, expect that while interest rates are likely to trend upward over the next few years, such increases should be modest and incremental. While that will likely make it challenging to generate good returns from fixed income, we have sought to manage this “interest rate risk” for some time. We believe that hiring managers to actively navigate the fixed income world will add value beyond just preserving capital, and hopefully negate some of the headwinds of a rising rate environment.
It is also important to remember another critical role of fixed income in a diversified portfolio. Our expectation is that fixed income will continue to serve as a “stabilizing” force in portfolios relative to other asset classes, particularly equities. With all the talk of bond market challenges, the reality is that even a bad year for bonds is usually quite tame compared to the volatility of the equity markets.
WAS SWP EXPECTING THIS?
Absolutely. We have thought for some time that the Fed would raise the federal funds rate, and that the market would adjust accordingly. While it took longer than we anticipated for this to become a reality, we have already positioned portfolios to account for yesterday’s Fed decision.
As always, we will continue to monitor all investments that we recommend to clients to ensure their objectives are being met, and will also continue to evaluate new strategies that might be additive to portfolios.
While we do not expect yesterday’s Fed actions to have a material impact on our clients’ portfolios, please feel free to contact us if you want to discuss your situation in detail.