A funny thing happened on Wall Street last week. After all the hoopla around raising interest rates and how it would send investors into a dither, Janet Yellen and the Fed finally made a move, raising rates by .25%. The reaction on Wall Street? Nothing. Nada. Zippo. In fact, the Dow climbed even closer to 20,000 the day of the announcement.
If you were paying attention to the headlines for the weeks leading up to the Fed meeting, that certainly wasn’t the reaction the media was expecting. But if you look at all the factors behind why no one seemed to care, it makes a whole lot of sense. Here are five reasons why many investors couldn’t care less about rising interest rates… and why you probably shouldn’t care either:
1. The hike was priced into stock prices.
The Fed’s decision had been widely anticipated, so investors were already trading based on the assumption that rates would be raised by at least a quarter percent. As the market continued to climb over the past four weeks, you can bet that every trade that took place happened with the hike as a forgone conclusion. And though rates did go up, no surprises at the Fed meeting meant no surprises on Wall Street the day after.
2. When you invest, you’re investing in real companies—not “the market.”
When you go to the grocery store, you go to buy tomatoes and milk, not the grocery store itself. The same is true with stocks. Interest rates inevitably impact the market as a whole, but when you invest in stocks, you buy ownership shares of real companies. Apple. GM. Exxon. You own something tangible that continues to grow in value, no matter what interest rates are at the moment.
3. Bonds are relatively stable assets.
The value of bonds dropped the moment rates went up, but that doesn’t mean you should suddenly switch to a 100% equity-based portfolio. Interest rates are inversely correlated to bond prices, which is why bonds are considered to be every portfolio’s safety net. First, they’re used specifically to hedge against much less predictable equity prices. Bonds are rationally priced based on term and credit quality. U.S. Treasury bonds are considered the world’s “risk-free” asset, with all other bonds measured by the “spread” between its credit rating and U.S Treasury bonds. Second, bond prices are mathematically quantifiable. That’s not the case for stock prices, which are determined at an auction between buyers and sellers and are impacted by fast-changing factors, such as the US and global economies, political instability, investor sentiments or sometimes seemingly nothing (like traffic jams). So don’t run from bonds. Instead, keep reinvesting in this stable asset class to balance risk and reward across your portfolio.
4. Interest rates can be unpredictable.
Sure, the economy is getting stronger. Unemployment is low. The dollar is strong. Inflation is creeping upward, if slowly. But even with the small hike, interest rates are still at historic lows (remember the ‘70 and ‘80s when interest rates were in the teens?). While the Fed sets the benchmark rate, the market sets longer-term rates, and the resulting “spreads” reflect investors’ sentiments about risk. Since there’s no way to know when rates will rise or to predict the shape of the yield curve (even the “bond kings” often guess wrong about the future), it’s wise to use bonds to stabilize your portfolio and provide liquidity to meet your cash needs throughout your retirement.
5. Higher interest rates don’t hurt your wallet over the long term.
Yes, rising rates hurt bond values, but as older bonds are sold and reinvested at higher rates, you can potentially increase your long-term returns. It’s also good to keep in mind that high quality, shorter-term bonds perform a lot like cash, providing necessary liquidity in a “safe” investment. (Note that this is not the case for high-yield bonds, which behave more like stocks.) Plus, while stuffing cash assets under the mattress has been a fine choice for the past decade, in a rising interest rate environment, your cash assets can finally start earning interest again. What a thought!
Ultimately, the Fed only sets benchmark interest rates. The increase only directly applies to the target of the federal fund's rate, which banks use to lend to each other overnight, by 25 basis points or .25% to a range of 0.50 to 0.75%. For the rest of the world, the market dictates the rates based on supply and demand (which is why mortgage rates can fluctuate no matter what the Fed rate may be). Of course, the market rate is often aligned with the Fed rate, so all interest rates are expected to continue to rise throughout 2017. Just remember that higher interest rates are the reward for strong policies that have been in place ever since the financial crisis. Those policies—including sustained low-interest rates—fueled growth, and today we have a stronger economy to show for it. That’s good news for anyone who is doing more with her money than stuffing it under the mattress.
Want to understand how your own portfolio can sustain rising rates? Email me to schedule a time to chat. As always, I’m here to help.