It is widely expected that the Federal Reserve will take its first “formal” step to begin increasing short term interest rates at its next meeting, which concludes on December 16th.
The Fed has kept short term interest rates very low for a long period of time, as they have left the fed funds target range at 0-.25% since 2008. It is likely they will increase the fed funds rate by .25%, to a range of .25-.50% on December 16.
We view this as a positive development. As the economy has strengthened over past years, the Fed is finally able to allow short term interest rates to rise. Fed Chair Janet Yellen, in various speeches and testimony before Congress this week, has cited improvements in the economy and job growth since the 2008-2009 recession. If the economy had not recovered, or was facing another recession, the Fed would not be considering increasing short term interest rates.
The Fed does not completely control interest rates. The Fed can take actions which influence the direction of interest rates, but interest rates are actually based on expectations of the many traders and institutions in the financial markets. For example, while the Fed has not yet acted, the 2 year Treasury note has risen from .25% as of 1/1/2013, to .68% as of the beginning of 2015 to .96% as of today. Short term interest rates have already risen by almost .75% in anticipation of the Federal Reserve beginning to raise interest rates.
One key is the pace of interest rate increases. The media will likely focus on whether or not the Fed actually takes its first step to raise short term interest rates on December 16th. What is more important is the Fed’s guidance and eventual actions regarding the pace and amount of future rate increases.
We think that the Fed will increase short term interest rates very gradually, such as .25% per quarter over the next year or two. If they follow this pace of increases, then the fed funds rate would be around 2-2.50% in December 2017. As short terms CDs and Treasury Notes pay very low rates today, the rates paid on these investments should increase correspondingly.
The impact on the stock and bond markets: The impacts of the Fed’s actions are tied closely to expectations and surprises. The challenge for the Fed Chair is to manage expectations, in a world and economy which are continually changing and obviously unpredictable. Given the fragile but recovering state of the US and worldwide economies, we would expect interest rates to rise very gradually over a period of years. The goal of the Fed is to encourage U.S. economic growth, with a dual mandate of fostering maximum employment and price stability, which they define as keeping inflation at around 2% annually.
Most people do not like surprises, and the unknown. Wall Street is no different. As the Fed grapples with issues surrounding interest rates, particularly when and by how much each future change should be, this is a source for volatility for the stock and bond markets.
As the future is unknown, this volatility is normal. The media will dwell on it. The stock market may over-react, both up and down, as it always has in the past. We feel the best approach is to focus on the long-term, and to have a well diversified portfolio of both stocks and fixed income holdings. We do not think that it makes sense to make bets on specific companies, industries or to risk your investments by trying to guess what the Fed will do. We would prefer to hold bonds or other fixed income investments of varying maturities, which will gradually adjust to whatever interest rates are in the future.
Mortgage Rates: As we have stated in the past, it is most likely better to get a mortgage today than a few years from now. In general, we would not advise you to pre-pay an existing mortgage, as mortgages with current very low interest rates will likely be a great asset to have 5-10-15 years from now.
Oil and Technology: There has been a huge drop in the price of oil over the past year. You see this when you put gasoline in your car. There is currently a tremendous worldwide glut of oil. Prices per barrel of oil were in the $80s-90s during 2013-2014. Since October 1, 2014, the price of oil has declined from $70 to around $40 per barrel today. This is a drop of 50% from a few years ago. Technological advances and other factors will likely keep oil prices well below past historical prices, which will benefit most aspects of the economy. This is likely to keep inflation low, which allows the Federal Reserve to raise interest rates, but not too rapidly or too high. Low oil prices translates into greater corporate profits (except for energy producing and related businesses), which is generally good for the stock market.
Summary: We remain very optimistic about the financial future. Now is an appropriate time for short term interest rates to continue their gradual rise. If there is volatility surrounding this action, you should not be deterred by it. It is normal for additional volatility to occur around the time of Federal Reserve meetings.
If you have questions about the impact of rising interest rates on your portfolio, please contact us.