Recently, Jerome Powell took the reigns as new Fed Chairman. Almost instantly, the stock market added volatility back into its vocabulary. The big discussion that followed was interest rates. More specifically, the frequency and amount the Federal Open Market Committee (FOMC) plans to increase interest rates.
Unfortunately, many of us don’t understand how this news affects the markets. Quite frankly, most of us don’t understand what it means for the FOMC to raise interest rates, as well as the practical effects.
Background on the FOMC:
The FOMC meets 8 times per year to discuss a variety of items, including short-term interest rates. As I mentioned above, we have a new, Trump-nominated Fed Chair in Jerome Powell (he took over for Janet Yellen on February 5th 2018). The consensus amongst market experts is Powell will continue to gradually increase interest rates (3-4 times this year) and unravel the Fed’s 4.5 trillion-dollar balance sheet.
Although most assume that a Powell-led FOMC will be very similar to Janet Yellen’s, it still ushers in a new era. That typically brings unease in the markets. Since the FOMC has such a massive say over the economy, people are hanging on every word looking for ques. Here’s what we know.
Federal Reserve has 3 core mandates:
- Maximize employment (usually assumed between 4%-5%).
- Achieve target inflation of 2%.
- Moderate long-term interest rates.
Taking a step backward, the Federal Reserve stepped in after the credit crisis of 2008 to stabilize and expand the economy. One of their main policies reduced interest rates to essentially zero, making it very cheap for individuals and corporations to obtain loans. This served as an injection into the economy. The interest rate policy held until 2015, when it was determined the economy could handle the normalization of interest rates. Since 2015, the FOMC has met to discuss the pace with which the economy can raise.
Deciphering the Interest Rates.
Since we assume interest rates will continue to increase, I’ll discuss what it all means.
- Rising interest rates can result in headwinds for a thriving stock market. Corporations find it more expensive to borrow money. When they borrow less, corporations tend to spend and hire less, too. Many investors use higher interest rates as an opportunity to remove stock positions in favor of bonds, which now are generating a higher yield.
- Higher borrowing costs do bleed over for the average consumer. A good example is higher mortgage rates. As borrowing for a home becomes more expensive, fewer individuals will look to purchase homes. Many will be forced to spend more income towards the mortgage, which reduces their disposable income for other goods.
- A benefit of normalizing rates is fighting rising inflation. If the economy expands too quickly, we could see fast rising inflation beyond the Fed’s target. This is the primary reason that both the Fed and investors keep an eye on reported inflation statistics. If it picks up beyond their 2% target, the fear is possibly four separate rate increases this year (rather than a previously expected three occurrences of .25% each). The FOMC will raise interest rates to combat inflation. The way to stop prices from increasing too quickly is to simply take money out of the economy. Most of the recent market volatility has been in response to economic reports showing inflation beyond expected numbers. The markets are constantly pricing in this information, as expectations for future rate hikes are changing.
- When interest rates increase, current bond prices decrease. If an individual holds a bond paying a fixed rate today, why would another investor pay current market value for a bond paying less than what they could purchase on a newly issued bond? It is important to note; however, if one holds a bond to maturity, they are still entitled to the principal back. One way to fight this is through floating rate bonds, which can be used to offset risk in a rising interest rate environment.
We do expect to see volatility remain, especially given the activity of the FOMC. While not necessarily a bad thing, volatility is a normal market occurrence. It allows for markets to price at fair levels. Expect peaks and valleys as new economic data enters the markets and investors react to expectations on the FOMC. The good news is we still have some really strong data as a backdrop (solid GDP, low unemployment, new tax bill).
Remember, while rising rates can initiate some short-term pains, they will ultimately benefit those who save and will continue to tame inflation.
At the end of the day, this is exactly why diversification reigns supreme. Going into uncertain market environments, you’ll want to make sure your risk is properly assorted. Take advantage of opportunities, but protect yourself from what lies ahead with a well thought out portfolio. Investors that diversify to match their risk tolerance and long-term goals ultimately benefit from:
- Smart places to withdrawal money, regardless of market occurrences.
- Exposure to the leading sectors of the market (with global investments to allow generation of returns from areas outside of those not performing well).
- Lower risk, relative to a more concentrated investor.