Letter to Investors: The Double-Edged Sword of Interest Rates
The Federal Reserve and Federal government have told us we have a strong economy – the Fed’s commitment to raise interest rates and to stop buying bonds may tell a different story.
Dear Colleagues, Clients and Friends,
The year is 2020, and the global economy has just been shuttered due to a viral outbreak. Supply is constrained as large numbers of workers and manufacturers follow stay-at-home orders. In response, the central banks of the world have expanded the money supply to stabilize Demand. First, our leaders tell us there won’t be inflation. Then they tell us it will be transitory. Jerome Powell assured us that if inflation was bad, well, then the Fed would just step in and do the obvious – raise interest rates, and stop buying bonds.
We were concerned with the economic impact of such a large expansion of the money supply with few industries allowed to operate.
Our imports went way up. It took 12 Quarters for imports to catch up after 2008. It took 6 Quarters after 2020. And as of December 2021, we are 24% above our pre-pandemic peak.
And now, in 2022, we have seen the highest inflation since 1982. With the most recent March reading coming in at 8.5%.
The economy we were told was strong, and since the Federal reserve had finally decided to stop using the word “transitory” it was time for them to step in and save the day. After much deliberation and a war between Russia and Ukraine, the Federal Open Market Committee (FOMC) determined to raise rates by 0.25% and to stop buying bonds in the market. They did so on March 16th, 2022 (despite setting a record for their balance sheet of 8.96 trillion later that month).
And now, the markets anticipate that the Federal Reserve will step in and raise rates again, clamping down on the inflation that has yet to show signs of transitioning back below 2%. The larger concern is that the supply constraints created by Ukraine and Russia, in combination with additional manufactured-war-time-spending by Washington, will result in even more inflationary pressure on prices in the market.
And while the Fed has been busy talking about fighting inflation, the double-edged sword has begun to appear. While equity markets have declined so far this year in anticipation of more rate hikes, what’s far more concerning is the bond market. If inflation rises and each dollar gets less valuable, then bonds are going to drop in price. If interest rates rise rapidly to fight inflation, then bonds are going to drop in price. The Federal Reserve has been instrumental to providing “liquidity” – that means buying bonds with printed money – since 2008. With the trillions of dollars spent in the last few years, they may not be able to stay out of the bond market for long.
The question is, how long is the Fed willing to sit on the sidelines and not buy bonds? From January 3rd through March 1st, the yield on the US Treasury rose 4.85% (that means the price is dropping). Since then, the yield has risen 59% to 2.71%.
This volatility is based on the Fed only needing to get interest rates to 2%. Imagine if they needed 5%, or 10% or 15% like the inflation in the 80’s (see previous article for more info on the inflation of the past). Imagine what this might look like as the Federal Reserve tries to sell even more bonds into the market with the goal of shrinking their balance sheet.
The current value of bonds could collapse. And that means you may not want dollars. If my dollar is decreasing in value today, then why would I want that same dollar 30 years from today in the form of a bond?
Equities – we expect this to be a volatile asset class in the near term. The economy is projected to enter a recession based on the Feds current Dot Plot, and at the same time inflation may provide upward pressure on nominal values (i.e. dollars being less valuable). We believe people will be seeking value, companies with strong cash flow and dividends, and companies that don’t require cheap credit to function.
Alternatives and Real Assets – we continue to believe that alternatives and real assets are important hedges for the current environment. Year to date, precious metals, commodities and managed futures have performed positively.
Fixed Income – if you believe the Fed will step back into the bond market to prevent a collapse, then you may want to consider the opportunity to deploy cash. We believe the market may still have room to fall.
Cash Value and Guarantees – Stability is important in times of volatility, and holding onto too much cash can be a bad idea if inflation does take off. Having access to capital that is not correlated with volatile markets is essential.
Lines of Credit – We recommend having these open for necessity or opportunity. Fixed lines of credit are ideal to hedge interest rate risk.
BIll Combs and The Olivia Team
Registered Representatives and Financial Advisors of Park Avenue Securities LLC (PAS). OSJ: 5280 CARROLL CANYON ROAD, SUITE 300, SAN DIEGO CA, 92121, 619-6846400. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representatives of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. WestPac Wealth Partners LLC is not an affiliate or subsidiary of PAS or Guardian. Insurance products offered through WestPac Wealth Partners and Insurance Services, LLC, a DBA of WestPac Wealth Partners, LLC. | Combs CA Insurance License Number - 0I49903 Olivia CA Insurance License Number - 0E57168, Olivia AR Insurance License Number – 2343024 | Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. | 2022-136575 Exp. 04/24
Data and rates used were indicative of market conditions as of the date shown. Opinions, estimates, forecasts and statements of financial market trends are based on current market conditions and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Past performance is not a guarantee of future results.