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Is It Good or Bad If the Fed Raises Interest Rates?

Is it Good or Bad If the Fed Raises Interest Rates?
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There’s a chance the Fed may hike interest rates this year—even in light of recent market volatility. Find out what the implications may be for your portfolio.

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RICK KARR:

This podcast begins with an interview that took place early in summer, but there’s an update toward the end. Back in the dark days of 2008 and 2009, when the economy seemed headed for the breakdown lane, one of the ways the Fed tried to get it cruising again was by slashing interest rates to historic lows, practically zero, to help free up some spending. Now the U.S. and many other countries are sitting on basically a zero rate.

Over the last few months, the Fed has danced closer and closer to an issue that has some investors biting their nails: the increase of the federal funds rate. That’s the short-term rate that influences everything from credit cards to mortgages to the value of U.S. Treasuries. After six years at close to zero percent, rates have to go up, don’t they?

I sat down with Kathy Jones, who keeps an eye on the bond markets as Charles Schwab’s senior vice president and fixed income strategist. She took me step-by-step through how interest rates got to be as low as they are, why she thinks the Fed is likely to raise them this fall, and finally, what investors need to do to be prepared for that.

We’ve figured some of you would want to cut straight to the climax, so to speak, and hear that last part before the rest of our conversation. So Kathy’s advice is to start by taking a look at your investment portfolio.

KATHY JONES:

Particularly your bond portfolio. If you have a lot of long-term bonds, we know that when interest rates go up, bond prices go down, all else being equal. So if you have a lot of long-term bonds, they’re likely to go down more in price than shorter-term bonds, because they’re more sensitive to interest rate changes. You may want to take a look at that and see if you’re comfortable with the prospect of that.

If you’ve really been someone who’s been sitting in cash, waiting for interest rates to go up, now may be the time. If rates go up, you might want to look at actually starting to invest a little bit and earning some interest on your money. It’s just time to kind of take a close eye to the portfolio and say, “Am I okay if rates go up from here?”

RICK KARR:

Okay. Now that we’ve heard Kathy’s advice, let’s rewind. We’re going all the way back to the first thing she told me, which is that the reason some investors are nervous about a Fed rate hike is there hasn’t been one in six years.

KATHY JONES:

So it’s been an extraordinarily long time of very, very low interest rates. So this is going to be a big change. And when the Fed changes the Fed funds rate, which is the basic rate, it affects the valuation of almost every other investment out there, because short-term U.S. Treasury rates are considered the risk-free rate.

When that risk-free rate changes, then the valuation of every other security changes. So for example, a corporate bond is based on some difference between the Treasury yield and the yield that the company might borrow at. And that’s true of almost every single security in the financial world. So when the U.S. changes the basic rate, everything else changes in value.

RICK KARR:

And the reason the risk-free rate is the lowest is because you know you’re going to get your money back.

KATHY JONES:

Right. So short-term borrowing from the U.S. Treasury is considered risk-free. You’re going to get your money back.

RICK KARR:

It occurs to me—why is zero so bad? I mean, if people are still lending the federal government money, buying the bonds, why do we need to move back to where we were before?

KATHY JONES:

Well, I think zero is seen as an emergency measure. So when the economy really tanked in 2008-2009 we had this horrible recession. But we had something even worse, a collapse of the banking system. The idea was that we have to do everything we can to support the economy—including the zero interest rates and a number of other policies that they pursued.

The feeling is now: we’re getting back to a more normal kind of economy, so we should have more normal interest rates. It should actually cost you something to borrow money. And they worry about speculation. That is, if money’s too cheap, it causes speculation.

RICK KARR:

And it’s also something that would explain why, if there is a big slowdown suddenly, you have no place to cut it.

KATHY JONES:

Yes. Then it gets more difficult. Then they have to try other—what they call tools in the toolbox—to try to help things along.

RICK KARR:

When you and I talked about this before we came into the studio, you said you’ve been hearing people hyping the dangers—saying that the Fed is going to raise rates—since 1988.

KATHY JONES:

Yes. People have been fearing higher interest rates for as long as I can remember. And they’ve been falling for pretty much my entire career. At some point, they will be absolutely right that interest rates are going to start going up.

RICK KARR:

And is that people remembering the 1980s, when it seemed like it was 20 percent, 25 percent?

KATHY JONES:

Yes. We had much more inflation back in the ‘70s and ‘80s. Interest rates went sky high. And it was a shock. No one was prepared for it, really. No one really could conceive of how high rates were going to go. And that was being done on purpose by the Volcker Fed, to kind of bring down the rate of inflation—and inflation expectations.

But we’re a long way from that. We’re not looking at a big spiral in inflation now. We’re really just looking at the Fed trying to get back to something that resembles normal interest rate policy after six years of extraordinary policy.

RICK KARR:

So what does the individual investor need to know here? Can you do an interest rates 101 for us?

KATHY JONES:

So a bond is basically a loan. When you buy a bond, you’re actually lending money to whoever it is who issued the bond, whether that’s the U.S. Treasury or a corporation or a mortgage entity. So, you know, that rate of interest is going to change in the marketplace depending on what the Fed does, depending on what inflation does, and depending on what investors demand to get for the money that they’re lending.

So interest rate 101 is: if the Fed raises short-term interest rates, that pretty much effects all interest rates, but not equally. So short-term interest rates may go up by, say, half of one percent. That doesn’t mean long-term interest rates are going to go up by that much. They can go up less, they can go up more. There isn’t one interest rate out there. There are lots and lots of interest rates out there.

RICK KARR:

Is the fear the people have based on when they think back to what happened in the 1980s, that’s just the worst that they know of. What’s changed since then? Why should they not be worried that that could happen again?

KATHY JONES:

Right. Well, I think the worry’s twofold. One is: the people who remember that era remember how fast and how far interest rates went up. It hurt the economy. It certainly hurt their investments. It was a really tough time. That environment is just so different from what we’re facing today.

But the other fear they have is that the bonds that they hold now will go down in value. So if interest rates are low, that means bond prices are high. If interest rates goes up, that means bond prices go down. And they worry about the bonds that they hold. Are they going to go down in value? Am I going to lose money? You know, what’s going to happen to my bond portfolio if interest rates start to go up after six years of being at rock bottom?

RICK KARR:

It seemed like this used to be a lot more of a guessing game when people would talk about Alan Greenspan wearing a certain color tie when he went to Capitol Hill. You told me a story earlier, I wonder if you could share with our listeners, about something you had to do even earlier.

KATHY JONES:

Right. Yeah.

RICK KARR:

Because the Fed used to not tell people what it was going to do.

KATHY JONES:

Right. So one of the things that alleviates my concerns a little bit is right now—we’re getting a heads-up from the Fed, right? They’re telling us, “Okay, we’re getting ready. This is how we’re planning to do things.” They’ve even laid out a whole process for the next couple of years of how they plan to undo everything they’ve done. But back when I started in this business, back in the Volcker era, the Fed didn’t talk to people. They changed policy without telling you.

So at that time, they were setting policy based on money supply growth. And this was our first true experiment with monetarism in the true sense. And so Thursday afternoons, the money supply numbers used to come out. And everyone would scrutinize those and try to figure out what the Fed would do Friday morning in their daily open market operations. And it was this big parlor game, this big guessing game, what they would do, because it would have a big impact on the market if they changed rates.

And so my job as a young research assistant was to stay late and analyze the money supply numbers so that my boss, on Friday morning, could look really smart and tell everybody what he thought the Fed would be doing the next day. But a lot of bets were placed on what what those money supply numbers implied.

RICK KARR:

Why is the Fed more transparent now?

KATHY JONES:

Part of it is required of them, and part of it is just a change in mindset. After the Volcker years, we got into a point where really, even earlier, Congress said, “We need the Fed to come and tell us what they’re doing and talk to us.” So we now have the Fed chairman having to testify at least twice a year in front of Congress. So we get that information.

And then things have evolved, I think, over the years, where they recognize that more information is actually better for people, to kind of reduce the volatility in the market. There’s no need to surprise people quite so much. So now we have the Fed releasing the minutes of their meetings regularly. They hold press conferences. They release projections. They talk. They all talk and talk. They may talk a little bit too much these days and give us too much information. But they are trying to sort of set us up for expectations so there’s not always a jolt to the market every time something changes.

RICK KARR:

Remember that I said at the beginning of this edition that Kathy and I had that conversation early in the summer. My next question would have given that away. Kathy’s answer helps explain what happened over the next few months.

You say that the Fed has laid out a sort of plan for the next two years. Is the plan to raise rates this fall? Are they going to go up this fall?

KATHY JONES:

Well, we think this fall. The most likely time is this fall based on the information we have now. They always say it’s data dependent, meaning it depends on what the economy and inflation do.

RICK KARR:

I got in touch with Kathy again after the Federal Reserve September meeting ended without the interest rate hike that a lot of investors expected. She said the Fed’s decision was driven by a change in the data that had started months earlier.

KATHY JONES:

The dollar got a lot stronger and the global economy got weaker. And as the dollar went up, what we see is that that holds down U.S. inflation because import prices fall, and it slows the economy because it makes our goods less competitive in the global market, so manufacturing slowed down. And all this created volatility in the markets. So I think they took a pause and said let’s assess how much this affects the inflation outlook, how much it affects the growth outlook, and we should hold off on a policy change until things have settled down a little bit.

RICK KARR:

The follow-up question I have to ask is, why did the dollar go up then?

KATHY JONES:

Well, I think there’s a couple of reasons, but they go back mostly to the Fed. You remember the Fed was doing quanititative easing, big bond-buying program, and they started to reduce their purchases in early 2014, and wound down the program in the fourth quarter of 2014—which meant they were providing less stimulus to the economy. So as the Fed was kind of shrinking the amount of liquidity it was providing the global economy, the dollar started to rise, and our interest rates are significantly higher than they are in most of the developed world. So holding dollars is more attractive for investors, and as the dollar goes up, that tightens monetary conditions even further. So I think tapering bond purchases was actually tantamount to tightening, and what we’ve seen is the economy react to that tightening in policy.

RICK KARR:

And that sounds just like supply and demand. There were fewer dollars to go around but people still wanted them, so they were worth more.

KATHY JONES:

That’s right. And even as paltry as our interest rates are, they’re significantly higher than they are, say, in Europe, where short-term rates are actually negative in some countries. So even if you’re only earning half of one percent or three-quarters of one percent in the U.S., that’s significantly better than negative one-quarter percent in, say, Switzerland.

RICK KARR:

One more question: when the Fed finally does move, are you going to breathe a big sigh of relief that you’ll get questions about something else finally?

KATHY JONES:

Well, we’ll probably just worry about when the next rate hike comes, but it would be nice to get it out of the way, so we can stop obsessing about the timing and start focusing on a lot of other things.

RICK KARR:

Kathy, it’s always a pleasure, thank you.

KATHY JONES:

Thank you.

RICK KARR:

That is it for this edition of the Insights & Ideas podcast brought to you by Charles Schwab. You can follow Kathy Jones on Twitter, that’s Kathy with a K all one word, K-A-T-H-Y-J-O-N-E-S. The Insights & Ideas podcast is available at iTunes; you can also get it at insights.schwab.com. Our producer is Matthew Nelson. I’m Rick Karr. Thanks for listening.

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. 

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