December Newsletter: Should You Be Worried About the Fed Rate Hike?

Posted by Alex Frey (@alexhfrey )

If your investing career is less than nine years old, you are about to witness something momentous for the first time: it is quite likely that the Federal Open Market Committee (FOMC, a part of the Federal Reserve System) will raise their target for the federal funds rate when they meet in the next two days. If so, this will be the first rate hike in more than nine years.

How big of a deal is this? Like most things in investing, it depends on who you ask, with responses ranging from it being a non-event, to it marking the end of an era of “cheap money” that has fueled another stock market bubble.

So which is it? Below, we try to take a more dispassionate look at the facts.

What is the Fed Funds Rate?

The Fed Funds rate is the interest rate that banks charge one another for short overnight loans. Banks are required to maintain a certain level of reserves as cash in their vault or deposits with the Federal Reserve System (the Fed). If their reserves fall short, they will make up the short fall by borrowing from another bank that has excess reserves. The rate is actually determined on a supply and demand basis by the banks themselves, but the FOMC (group that sets Fed policy) sets a target rate. To force the actual rate towards the target rate, the FOMC buys or sells treasury bills or other short term federal agency securities. By selling securities, the FOMC pulls funds away from banks and tends to raise the rate that they charge each other. Buying securities has the opposite effect. We should note that banks can also borrow directly from the Federal Reserve. When they do, they pay the discount rate, which is directly set by the Fed. It is higher than the federal funds rate, and banks prefer not to use it.

Why It's Important

Ostensibly, the federal funds rate might not seem to be very important. The rate that banks charge each other is much lower than the rate that consumers pay on their credit cards or other consumer loans, and it is also much lower than the rate that businesses pay for business loans. However, when the FOMC conducts operations to affect the federal funds rate, it is also expanding or contracting the money supply. Purchases of securities by the FOMC adds funds to the banking system, and sales withdraw funds. When more funds are available, supply and demand drives down interest rates; when fewer funds are available, the reverse happens. So other interest rates tend to follow the federal funds rate up or down.

However, the effect of the fed funds rate on other interest rates is sometimes quite muted. Figure 1 compares the fed funds rate and the rate for a 30 year fixed rate mortgage for the time frame from 2000 to 2015. In the 2004 to 2006 time frame, a sharp rise in the fed funds rate resulted in an almost imperceptible increase in the 30 year mortgage rate. So, longer term rates may not directly follow the federal funds rate, but they are likely to move in the save direction.

You may be wondering about “quantitative easing” and how it fits into this picture. Quantitative easing was the Feds attempt to directly influence long term interest rates. Instead of buying short term securities, as they usually do when trying to control the fed funds rate, they bought longer term securities such as mortgages issued by Freddie May and Fannie Mac. There is debate about how much this program helped the economy, but in any case, the program ended in 2014.

fig1.png Figure 1: The federal funds rate compared to the 30 year fixed rate mortgage rate. Data taken from the Federal Reserve Economic Data.

Why the Fed is Raising Interest Rates Now

Higher interest rates tend to slow economic growth for obvious reasons. Higher rates make it harder for consumers to purchase big ticket items, and they make it harder for businesses to borrow to expand. So why would the Fed want to raise interest rates? Why not have permanent low rates? The answer is that the Fed is also charged with maintaining a stable currency without too much inflation. By encouraging borrowing, low interest rates can cause the economy to expand too fast, so that competition for labor and supplies drives up prices. The goal of the Fed is to encourage the economy to grow as fast as possible without causing inflation, but no faster.

So what is the present situation? First, the federal funds rate is very low (essentially zero) by historical standards. Figure 2 shows the variation in the rate from 1952 to present. The case against a rate hike seems fairly clear. The economy has been growing fairly slowly. The average growth rate since the end of the Great Recession has been about 2.1% per year. The long term average growth rate from 1947 to 2015 is about 3.2% per year, so on this basis, it would not appear that the economy is overheating. Inflation, as measured by the consumer price index, has also been very low as shown in Figure 3. It is currently well below the Fed’s target rate of 2% per year. Falling commodity prices have helped to keep inflation in check and also indicate that there is no shortage of basic supplies. Also, the U.S. dollar has been increasing in value making imports cheaper. A rate hike could draw in investments from abroad, which could further increase the value of the dollar. This helps to keep inflation in check, but it can create more competition for U. S. producers.

fig2.png Figure 2: Federal funds rate from 1954 to present.

fig3.png Figure 3: Rate of change in the consumer price index.

The case for a rate hike is more nebulous.

First, the Fed is very aware of the fact that there can be long lags between actions by the Fed and results in the economy. The economy is not a simple machine that responds promptly to commands. The Fed has models that attempt to predict future directions, and apparently those models are predicting some growth for inflation. Stemming inflation is much harder after it has started to occur. It is better to stop it before people develop inflationary expectations. In the late 70s, the fed funds rate had to rise to nearly 20% to cut off the inflation that was occurring at that time. By acting early, the Fed hopes to avoid this scenario.

Second, unemployment has declined to about 5%, which is considered to be full employment by many economists. This indicates that the crisis caused by the Great Recession is over. Third, the fed funds rate is currently very low by historical standards, as shown by Figure 2. There is an argument for returning to “normalcy” now that the Great Recession is over.

But perhaps the most important reason has to do with credit expansion and the creation of bubbles in the stock and housing markets. In the late 90s, the stock market soared to extremely high values (as measured by the average price to earnings ratio), while the fed funds rate remained constant and inflation was subdued at about 2.6%/year. The resulting crash in the stock market was one of the causes of the recession in 2001. Likewise, in the December, 2001, to December, 2005, time frame, housing prices grew by 56% (40% after adjusting for inflation) while inflation was low (12% for the four year period), and the fed funds rate was low (see figure 2). The crash in housing prices that followed was a major cause of the Great Recession. So in addition to consumer price inflation, the Fed needs to be concerned about asset price inflation, and once again stock prices seem high (but not nearly as much so as in 2000) and home prices are increasing faster than inflation (about 4% in the last year, per the Case-Shiller index).

What Does a Rate Hike Mean for Investors?

So if a rate hike happens, what does it mean for investors? To the extent that a federal funds rate hike carries over to other rates, a rate hike is clearly bad for bond investors, at least in the short term. As interest rates go up, the prices of existing bonds come down. Long term bonds are affected much more than short term bonds.

In general, the effect on stock prices is also negative for several reasons. First, the cost of borrowed capital will go up leaving less for stock holders. Second, investors who are choosing between stocks and bonds will find bonds relatively more attractive as bond yields rise. Finally, the most common way of evaluating the price of a stock is to look at the sum of expected future earnings discounted according to a baseline interest rate. The baseline rate is often taken to be the 10 year treasury rate, and as this rate goes up, the predicted stock value comes down. With that said, stock prices certainly do not follow the fed funds rate in any simple, direct way. Figure 4 shows the relation between the Wilshire 5000 stock index and the federal funds rate over the last 25 years. While peaks in the federal funds rate and peaks in the Wilshire 5000 are clearly related, stocks can continue to rise for a considerable time after rates begin to go up.

Also the market is unlikely to make any drastic moves in response to the announcement of a rate hike. That's because the event has already largely been anticipated, and therefore should be “priced in” to the current market prices.

fig4.png Figure 4: The relation between the federal funds rate and stock prices over the last 25 years.

So what should an investor do? Yet again, it is hard to come up with a better approach than sticking to the systematic rules of the Ivy Vest portfolio. Trying to time the market is very difficult and more likely to hurt your long term gains than to help them. The Fed may or may not start to raise interest rates in December. If it does, it has indicated that the rate of increase will be very slow, and they could well turn around and reduce them again. Trying to outguess the Fed is as difficult as trying to outguess the stock market. Both depend on future economic conditions, which are hard to predict. The Ivy Vest portfolios give you wide diversification and systematic rules that cut losses in tough environments, and those are your best protections against the vagaries of the future.

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By Alex Frey