Interest Rate Update

With all the political news over the past few months it's natural that topics like the Fed and interest rates were pushed to the back burner for a while. There's only so much time in the day for financial news, right? But this has changed in the past couple of weeks and markets are reacting. As our economy continues to improve, and the Fed is meeting again today and tomorrow, investors are focused on what increasingly looks like another short term interest rate increase.

A quick reminder: The Fed has two mandates from Congress. One is to keep inflation in check, and the other is to foster so-called full employment. Arguably, the tools the Fed uses for this are blunt but they do have wide effect. The tool we hear about most is the periodic setting of the federal funds rate, a key short term rate that percolates throughout the economy.

For example, the Prime rate linked to adjustable home equity credit lines and many credit cards is typically 3% over the federal funds rate, currently at 0.75%, making the Prime rate 3.75%. As the Fed raises rates, Prime goes up and so does the cost of borrowing for millions of Americans. On the flip side, savings accounts and bonds end up yielding more, but there's a lag to this that can last awhile.

As we are all aware, it was in December 2008 that the Fed lowered short term rates to zero and started a variety of programs to help stave off economic collapse and, eventually, to stimulate growth. A few years later the Fed established a 2% target for so-called "core" inflation and has been striving ever since to make that a reality. A big part of this effort was in keeping short term rates low for what the Fed referred to as an "extended period", even as a variety of metrics began to show some growth.

But now the economy is doing better. The primary core inflation metric the Fed uses is at just about 2%, job growth continues to be positive, the average worker's earnings are finally moving up, and the labor force participation rate has started to increase (while still at low levels). Add to this that the current 4.7% unemployment rate is right in the middle of the Fed's target range (from 4.5% to 5%) and it's harder and harder for the Fed to not raise rates again. Chair Yellen and other voting members of the rate-setting committee have said as much in the past couple of weeks, essentially giving the markets a heads-up for the potential increase.

In January last year, the Fed forecasted raising rates four times in 2016 but ended up only raising once. This year they have forecasted three increases. As of a few weeks ago, the bond market was giving a rate increase this month a 30% chance, but this has since jumped to 90%.

If they do raise tomorrow it would be two bumps in three months, but only totaling three in the preceding eight years. While it's possible that they'll hold off, it's unlikely, and that's what the bond market is reacting to.

Through last Friday core bonds (high quality bonds like Treasurys and investment-grade corporate bonds) are down a hair so far this year. Municipal bonds are up about 0.5% and high yield bonds (formerly referred to as "junk bonds") are up about 2%. U.S. stocks are up 6+% in the same period so it's natural to wonder about ditching bonds in favor of stocks. But it's important to remember the primary reasons to own bonds in the first place.

First and foremost, investors own core bonds with the "safe" portion of their savings. It's the portion where big declines would hurt most. While this is typically lower for younger folks with lots of time to invest, for those gearing up for, or living in, retirement, the portion can be substantial. Interest income is generated from bonds, but little growth above the interest should be expected on this portion because risk is low.

The reason why it's low is that each bond is a loan backed by governments or high quality corporations, so there is little risk of default. The safer the bond, the less it earns, but that's a tradeoff most investors are willing to make with some portion of their savings.

The second reason to own bonds is simply that they're not stocks. What I mean by this is that bonds typically hold their value when the stock market is falling and, because of this, help control the amount of downside risk you take with your overall investment portfolio.

The issue with this, however, is that when stocks are rising, and when interest rates are too, bonds can underperform stocks for a prolonged period. But as this gets discouraging, try to remember an old saying about investing in bonds: It's more about the return of principal than the return on principal. Repeat it like a mantra.

Have questions? Ask me. I can help.