Fed Reserve, Stock Market Actions and a WWM Milestone

The Federal Reserve again increased short term interest rates by a quarter of a percent on Wednesday. It signaled that it will do the same twice again later this year.

This is good news, as the Federal Reserve’s actions to regularly increase interest rates is reflective of the strength in the US economy. The Fed noted that economic activity has risen “at a solid rate,” which is an upgrade from their May statement, when they called economic activity “moderate.”

Federal Reserve Chair Jerome Powell stated in a press conference that the US economy is in “great shape” and that “most people who want to find jobs are finding them.”

It is important to understand the Federal Reserve actions and comments are not considered stock market forecasts. They are economic updates and future economic guidance, which are not always accurate.

The Federal Reserve actions are reflected in the significant rise in short term interest rates over the past year, as shown in the table below. However, as the Federal Reserve cannot directly control longer term interest rates, those rates have risen, but not nearly to the same degree as short term interest rates.

June 2017
June 2018
2 YR
US Treasury Note
1.37
2.56
10 YR
US Treasury Bond
2.21
2.96
30 YR
US Treasury Bond
2.78
3.07

 

Note that the current spread is quite small between the 2 year interest rate and 10 year interest rate, of only around .4% (2.96%-2.56%). There is hardly any increase or premium in the interest rate between the 10 and 30 year maturities. This is what is referred to as a flat yield curve, as there is not much of an increase being paid to hold longer term fixed income securities.

In a more normal, steepening yield curve, the interest rate would gradually increase as the maturity lengthens. In a steep yield curve environment, the 30 year bond would pay much more than a 10 year bond, which would pay more than 5 or 2 year maturities.

What does this mean and why?

Some forecasters say that a flattening yield curve is a sign of a future economic downturn, or a recession. We do not necessarily believe this is the case, at least in the near term.

This situation will present a challenge for the Fed if longer term rates do not increase in the next 6 months. If the Fed increases short term interest rates .25% in September and again in December, or faster, then short term rates would be around 3%, which is equal to or greater than long term rates now. This would be called an inverted yield curve, when short term rates are higher than long term interest rates. If this were to develop, it is not necessarily indicative of a problem or a bad thing, it is just unusual for a healthy and growing economy.

As it affects our clients and our investment strategy, rising short term interest rates provide an opportunity for those who own fixed income investments, such as bonds or CDs, to earn more interest on their fixed income allocation. This has been a long time in coming.

As your current fixed income investments mature, we will reinvest them at greater interest rates than before, so your interest income will increase. Over time, this should be a significant increase in interest income.

We do not place major bets on the direction of interest rates by bunching maturities all in one year. We always evaluate the interest rates and various maturities which the market offers at that time, for the most beneficial combination. It is possible that we would buy a little bit shorter maturities now than we would have a few years ago, as there is not much premium to hold fixed income investments beyond 5 years. But fixed income markets can change quickly and we would react as appropriate.

As a reminder, when interest rates rise, the value of your fixed income investments will decline temporarily in value/price and then that price will recover as they near maturity. You should not be concerned about these temporary declines, see our recent blog post, Why Bond Fluctuations Should be Ignored.

The US stock market has been strong in the second quarter of 2018, with small and value asset classes outpacing the large company S&P 500. International and Emerging Markets have trailed these asset classes during the current quarter.

We remain confident in our long term investment strategy and philosophies, as they continue to be profitable for our clients.

This week marks a writing milestone, my 200th blog post since I started writing weekly four years ago. This is the 4th straight year that I have written nearly every week since June, 2014.  Prior to that, I had sporadically written 145 essays between 2009 and April 2014.

Writing weekly is one of the most important services our firm provides to our clients, as we can communicate in a very timely and regular manner to you. We can convey and reinforce our investment philosophy, principles and beliefs in real time.

These are intended to be relevant and informative.  Reading these blog posts regularly, you should have greater clarity about your investments.  You should have more confidence in our philosophy, especially when the financial markets are challenging.

Hopefully, you better understand the benefits of being rationally optimistic, focusing on the long-term and on what you can control, rather than on the day-to-day news and market volatility.

I am convinced that we are better financial advisors by writing these weekly blog posts.  We are passionate about being excellent advisors.  Writing makes me think.  We are more aware of questions and issues our client raise, as these are likely future blog topics.  We are more curious.  We research topics to provide information which will be useful to you.

When I committed to writing every week, it took courage.  I didn’t know if I would be able to do this every week.  I didn’t know if I would have the discipline.  I enjoyed writing earlier in my life as a high school newspaper editor.  The weekly commitment gave me structure, which led to developing greater capability.  The more blog posts I completed, the greater my confidence has grown.

This concept also applies to each of you, as our clients.  At one time each of you made the decision to work with our firm as your financial advisor.  This took courage and commitment.  It was likely a significant change for you.  As you become more comfortable with our capabilities, your confidence in our advice and philosophy grew.

Thank you for your confidence and for reading!

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