Investment Workshop 32: Up Goes Interest Rates

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

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Last week on June 14th, the US Federal Reserve did something that just a few years ago would have been unthinkable: they hiked interest rates. This is the 3rd such hike since December, bringing the Federal Fund benchmark rate from 0.5% in 2016 to 1.25% today. But what does it mean? Why would the Fed do that? And how will that affect our Investment Portfolio?

Let’s talk a little about that, shall we?

What The Hell Is This Thing?

As we’ve written about before, the Fed Funds rate is the benchmark interest rate that the US central bank sets. It determines how much the US government will pay for issuing government-backed debt. Seems straightforward enough so far, right?

Here’s the fun part. In the bond trading world, US treasuries are considered the only risk-free debt in the world. The US government is so big and rich, the logic goes, that they would never ever default on their bonds. You can agree or disagree with that statement, but that’s the basic assumption that the entire bond market is based on.

How every other debt instrument is priced, therefore, is at a spread relative to this risk-free rate. For example, if the risk-free rate were 2%, and a certain corporate bond was trading at 7%, that means that the bond market believes 5% (or 500 basis points, as the cool kids call it) is fair compensation for taking on the extra risk of holding this corporate bond (which may default) vs a US government bond (which cannot default). This bond is pricing in a 5% risk spread.

And now repeat this for every debt or loan instrument out there, everything from preferred shares to business loans to the interest rate on that credit card you got down at that sketchy gas station. Everything is priced as a risk spread relative to the risk-free rate, which is in turn set by the Federal Funds rate.

And this effect, by the way, extends across borders as well. If you have a bond from a foreign government like, say, Canada, then the interest rate that bond is trading at is judged based on Canada’s relative riskiness to the US of A.

That means that when the Fed Funds rate changes (like it just did), and assuming nothing changed in the riskiness of each loan, the interest rate of every single mortgage, credit card, PLC, no matter what country you live in, changes by the same amount. When the Fed moves, everyone’s interest rate changes as well. So interest rate moves by the Fed are hugely important because they affect basically everyone.

It’s All About Inflation

So why would the Fed so this? One word: Inflation.

The Fed has many mandates and responsibilities, such as stimulating the economy, keeping the housing market stable, helping drive the unemployment rate lower, etc. But the primary job of the Fed is to keep Inflation in check. Specifically, within a comfortable range of 1-3%. This keeps the economy growing while not screwing up the value of the dollar, as we wrote about in this previous article.

So in times of economic stress like in 2008/2009, it’s the Fed’s job to drop the interest rate in order to keep the economy from falling off a cliff. But when the economy improves, it’s also the Fed’s job to slow the economy down and prevent it from overheating.

It’s a bit counter-intuitive, I know, but when the economy is SO hot that literally everyone who wants a job has one, the workers start demanding more and more raises from their employers (since they have so many options in terms of jobs). This forces the employers to rapidly raise their prices on the goods they sell, which causes their employees to demand even higher salaries, and so on until you’re stuck in a hyper-inflation loop. That’s not good either.

So the Fed lowers interest rates when the economy’s doing poorly, and raises it when the economy starts to grow too fast, and all to keep inflation in check.

Will This Fuck Up My Investments?

The short answer, no.

It might fuck up your debt if you, say, have a jumbo mortgage or massive credit card debt that you can barely keep up with, but if you’re invested in a low-cost Index-hugging ETF-based portfolio like the one we’re building in the Workshop, then you’re fine.

However, it may cause some short-term fluctuations.

Recall that we normally have a balance between equities and fixed income because they tend to counterbalance each other. When something big and scary happens in the news, money flows from equities into fixed income, and when something good happens in the news, money flows the other way around. So the two are supposed to move in generally opposite directions.

When interest rates change, this no longer applies. This is because interest rate changes affect both equities and fixed income in the same direction.

If interest rates fall, fixed income assets like bonds go up in price because higher-yielding assets just became more valuable. Meanwhile, stock markets go up as well because it makes it cheaper for companies to obtain money to grow their businesses. When interest rates fall, both fixed income and equities move upwards.

Conversely, if interest rates rise (like they just did), fixed income assets like bonds go DOWN because they have to be priced more attractively to compete with the higher rates you can now get from the federal government. And at the same time, equities go down too since money is now more expensive for them to obtain.

Check out what happened last time the Fed raised interest rates on December 14, 2016.

And here’s what just happened on June 14th…

But don’t fall into the trap of thinking “GAH! Bail out! Interest rates are making everything go down!”

Remember, the reason that interest rates are rising is because the economy is doing so well. US unemployment is down to 4.3%, the lowest level since 2001. Q1 GDP growth clocked in around 4% annualized. Hell, even CANADA’s GDP grew at 3.7% annualized, and that’s with all that fighting about cheese or wood or whatever the Hell we were fighting with the Americans about. So the economy’s actually doing GREAT.

Which means even if stocks and bonds dip in the short term, that dip is exactly that: short term. Over the medium/long term, a strong economy is good for the stock market. And if you pull back on that chart of the  S&P500’s performance so you can see what it did between that December 2016 rate hike and this one…

Those short term dips ended up being nothing more than inconsequential pauses that were part of a longer-term upward trend.

And with that, we are done! Thanks everyone, and see you next Wednesday!

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

16 thoughts on “Investment Workshop 32: Up Goes Interest Rates”

  1. Our financial advisor says that you don’t want to buy bonds (or at least, you’ll buy less bonds) when interest rates go up. But this seems counterintuitive to me. Is it better to buy them when rates are higher or when they’re lower??

    1. The trend is more important than the rate. If rates are going higher than the value of the bonds you are currently holding will go down, because investors will be buying bonds that are being issued at the higher interest rates.

      Having said that, if you are happy with the rate, and do not care about the value of your bond (because you will not be selling it), then go for it, it doesn’t really matter.

    2. The risk is that rates keep going up after you buy bonds. When rates go up, bond prices drop. For every incremental change. Unless you buy right at the peak -ha, ha, good luck with that – you will lose some money in all bond accounts when the rate goes up.

    3. Resist the urge to time the bond market, it’s just as impossible to predict when and how much interest rates move as it is for stock prices. Stick to your asset allocation.

  2. Investors should be calmer about keeping or buying bonds this time around. While the raw economic indicators look good, I think the US economy is still relatively weak when compare to previous recoveries. Interest rates are rising at no more than 1/2 the speed of previous recoveries – in 2005, the Fed raised rates every meeting. The new wrinkle is the Fed selling securities. It should act as a 2nd means for raising longer term rates, but it may leave short term rates alone. Overall, I still think the changes will be more gradual than in the past.

    1. The Fed actually isn’t selling securities, they are just not re-investing as much of the money from maturities of MBS and Treasuries as they had been doing. It’s starting with 10B a month (6B treasuries and 4B MBS) roll-off and will increase it every quarter until it gets to 50B (30B Treasuries and 20B MBS) by early 2019. This obviously won’t be a huge change given its 4.5T balance sheet but will help try to normalize the yield curve which is pretty flat right now.

  3. Does anyone have any thoughts on REIT’s, which are obviously affected by the interest rate hike?

    My Rio-Can is suffering a bit. I know you can’t give individual advice, but I may move to a more general REIT fund.

    1. Yup, my preferreds (and REITs) are doing the same thing.
      Remember, you bought REITs for the yield, and that was locked in when you purchased it. The capital value shouldn’t matter.

  4. I think it’s good that they’re finally starting to get serious about normalizing. That way, worst case scenario, if we hit a wall again they can lower rates again and even worse of a situation they can do additional rounds of bond-buying. I just don’t feel comfortable when the Fed is out of ammos. So it’s good to get back to a base level. At some point they’re going to do “helicopter money” and the previous fed chairman, bernanke, wasn’t all that against this idea (basically dropping money out of the sky – figuratively speaking). We’ll see. Only time will tell.

    1. Ah yes, good times. When Bernanke started printing money in QE. That dropped the USD so much that it was at parity with the CAD. We enjoyed those days quite a bit.

  5. My friend sent me a screenshot from his stock app saying, “Did you see this crash?”
    Basically what we was saying was “Skyes are falling!”. My reply to him was
    – That’s exactly why I deleted all these stock market apps from my phone. I don’t care about short term. I am mo interested about long-term

    1. Yeah, I used to have those panics too. First it 2008, then it was Grexit, then it was Cyprus, then it was Brexit, then it was Trump. After the 5th “the sky is falling” moment you just kind of get bored with it.

  6. I love this simple explanation!

    There is so much panic around these tiny changes, and part of that is from mainstream media who loves to flash ‘BREAKING NEWS’ as often as possible.

    Long-term trends are so much more important, and understanding their underpinnings is what anchors me. It’s good to read articles like these that do the same 🙂

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