Federal Reserve actions: A "Q & A" to explain recent events

Our goal is to provide our clients with comfort and security.  To achieve this, providing clarity and understandable explanations about financial matters is important.

What is the mission of the Federal Reserve?

The Federal Reserve has a legal dual mandate: to foster maximum employment and price stability (which they have defined as keeping inflation around 2% annually). The Federal Reserve feels inflation is currently running below 2% and longer term inflation expectations remain stable. The Fed wants to bring the unemployment rate to at least below 6.5%, from its current level of around 7.5%.

What occurred at the Fed meeting on June 19th?

Last Wednesday, the Federal Reserve held their regular meeting, which concluded with their written press release regarding interest rates and the economy. Fed Chairman Ben Bernanke then held a press conference and further elaborated on Fed policy.

The Fed’s statement following their June 19th meeting did not change significantly from their May meeting. To meet the above goals, the Fed plans to continue their current asset purchase program (referred to as QE, for quantitative easing). They will continue to purchase $40 billion per month of mortgage securities and longer term US Treasury securities of $45 billion per month. The Fed feels these steps are needed to maintain downward pressure on long term interest rates, support mortgage markets and “make broader financial conditions more accommodative.”

How have interest rates been changing?

Interest rates, as defined by the 10 year US Treasury note, have risen dramatically over the past year and since the Fed meeting in particular. The 10 year rate was around 1.6-1.7%% during June-September 2012.  In January 2013, it had risen to around 2.0%. From June 3 to June 24, 2013, the rate rose from 2.13% to 2.5-2.6%.

What is our view of future interest rates?

While we do not have a crystal ball and do not make interest rate predictions, a few things are clear. Interest rates have been historically low due to the long time it has taken for the economy to recover. We think the bond market may have over-reacted to Bernanke’s comments.  There was initial fears that the Fed was going to influence long term rates to rise higher and sooner than many on Wall Street had anticipated prior to June 19th.

We think short term interest rates will be still be very low for the next year, and maybe longer, based on the Fed’s comments. The vast majority of Fed governors expect short term rates to continue very low until 2015 or 2016. The Fed has a harder time “controlling” longer term interest rates, such as mortgage rates and the 10 and 30 year US bonds. The Fed’s intent is to hold these rates low until either the unemployment rate has declined to 6.5%, or even lower, and/or inflation expectations are greater than 2%.

What do we think of the recent rise in longer term interest rates?

As shown above, rates have been rising for a year, though not in a straight line. The rise did not begin just in the past few weeks. As many economic indicators show, the economy has improved from 2008-2009 levels (such as car sales, housing starts and sales, housing values, employment growth). We think the rise in interest rates is a gradual process that is good and healthy for the economy, as long as the increase is not too fast or high. We do not anticipate this occurring.

What actions should you take or consider, based on these events?

As interest rates rise, the prices of bonds and bond funds will drop in value. For nearly all of our individual clients, we have recommended to hold individual bonds for this reason. While a bond’s price may temporarily decline, it will not be a permanent loss upon the bond’s maturity. If you hold a bond fund, you will incur a permanent loss in value as interest rates rise. If you own a bond fund or know someone who does, particularly intermediate to long-term funds, please contact us to review whether a change in your portfolio is in your best interest.

If you have not refinanced in the past few years, and you can qualify, you should begin the process immediately.  Though mortgage rates have risen, they are still historically low and refinancing still makes tremendous sense.

Given the very low historical interest rate levels that currently exist, we do not recommend paying additional principal on mortgages and other low interest rate debt. We think debt at these interest rate levels will be viewed very positively in the next 3, 5 and 10 years. So, it generally does not make sense to pre-pay these debts at this time.

What is the impact on the stock market of the recent events?

The stock market in the US has been quite strong for the first 6 months of 2013, up over  10%. We think volatility will increase, as Wall Street tries to understand and predict future Fed actions. Wall Street will also have additional anxiety over the naming of the next Federal Reserve Chairman, which will play out through the remainder of 2013.

We continue to be long term investors and have a long term positive view of companies and countries’ general resilience and ability to adapt and innovate. It is not possible to accurately time the stock market. Thus, we will continue to adhere to our core investment principles, which are not affected by the rise in interest rate increases.

Please contact us if you would like to discuss these matters further.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *