Interest rates are going up. In fact, they have begun rising already. Since December 2015, the Federal Reserve has raised the overnight interest rate from 0% to 1.25% through five quarter point increases. They are also signaling one more in December and up to three of four more next year. And if you take into account a coming leadership change at the Federal Reserve, these plans could become more aggressive in removing accommodation. So what does this mean for portfolios?
The effect on equity securities will be muted, for a while. Equities typically like a little inflation; we are in a sweet spot between 1.0 and 2.0%. Equities also like interest rates to keep themselves in a range too. The boundaries of this range can change based on market conditions, but we are in another sweet spot there too. Rates are still low enough to encourage businesses to borrow so they can do their own investing. And they are too low to act as competition for investor capital. As rates rise these factors will change, but we think that is rather far away. Equities can exist quite happily with rates staying below four or five percent and nobody is talking about those levels yet.
The effect on fixed income is more immediate and surprising, based on what you own. Fixed income prices are based on interest rates and the math that calculates your cash flows back to today. When rates go down, fixed income securities’ value goes up because your fixed cash flows are now worth more in a lower rate environment. The reverse is also true: When rates go up, values go down because your fixed cash flows are now worth less in a higher rate environment. That is where we are now. The Fed is in the process of raising rates, and to accelerate the trend, it is also unwinding the unprecedented purchase of over three trillion dollars’ worth of treasury’s and mortgage backed securities added to its balance sheet over the past decade.
When the Federal Reserve raises interest rates, it is the overnight rate to which we refer. They don’t have as much direct influence over long-term rates. Their intention is that as the overnight rates move, long-term term rates move as well. This is why you should be aware of the average maturity, or life, of your portfolio. The longer the term of your securities, the more volatile their price fluctuation will be due to their having more cash flows to consider. Those additional cash flows also help explain why long-term rates historically have always been higher than short-term ones because of the added period of uncertainty about the economy and politics. As long-term rates go up, the underlying securities’ value will decrease much more than that of short term securities.
That is why we have kept the average weighted life of our clients’ portfolios short for some time, in anticipation of what is now happening. If you don’t know the average maturity of your portfolio, you should find out. If your portfolio has an average life longer than three to five years, you should re-examine it now.
Bonds in general are seen as a hedge against volatile equity markets and a source of reliable income; they are seen as the ballast for a portfolio. For years, the income opportunity has been muted as rates were kept at zero for so long. That is slowly changing now, but there are ways to minimize losses along the way. It is not a time to be complacent.