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Here we Go Again

Here we Go Again

April 26, 2024

Here we Go Again

After a nice yearlong rally, interest rates are heading higher – dragging down stocks and bond prices.

This time it’s not the fed who is acting – it’s the markets.  

The Federal Reserve has been holding its interest rate steady for quite some time now.  The idea was to raise rates enough to slow the economy down, thus easing inflationary pressures.  This is what caused the rates on your money market funds, online savings accounts, and other “short term” deposits to soar. 

Until this month the market believed that the Fed would be successful.  It believed that inflation would quickly recede and the Fed would be able to lower rates again.  Since the expectation was that higher rates would be transitory, the Feds action never fully passed through to longer term rates.  This is why until recently we have this weird and unusual situation where you can earn 5.5% in an online savings account, but only 4% in a 5 year CD, or a 10 year Treasury bond.  

This situation is referred to as an “inverted yield curve”.  When long term rates are lower than short term rates, it is because the market assumes that rates will be heading lower.  What causes rates to move lower?  Well, an economic slowdown (aka recession) is the usual culprit.  Inverted yield curves have been a good predictor of recession.  But as I write this, the curve has been inverted for almost 2 years – and no recession.  But an inverted yield curve is unnatural.  It can’t persist!  Inevitably one of two things will happen.  One:  The economy will slow, inflation will come down, and the Fed will cut short term rates, restoring the normal relationship where longer term rates are higher than short rates, or....  Two:  The economy and inflation will continue to run hot, despite the higher rates, and the market will bid up longer term rates until they exceed the short term rates.    

The problem is that the Feds higher rates have not licked inflation.  Price pressures continue to smolder.  At the same time, the government is borrowing unprecedented amounts of money to pay for spending it can’t afford.  This deficit spending forces rates higher in two ways.  First, by creating money and injecting it into the economy, it is increasing demand for goods and services, it is by its very nature inflationary.  Second, the governments huge demand for borrowed money pushes interest rates higher.  In essence, our elected officials are doing everything they can to fight the Fed by throwing fuel on the economic fire even as the Fed tries to douse the flames!  (by the way – this isn’t a political commentary – deficit spending has been out of control ever since the financial crisis of 2008 with a rapid escalation during the Covid pandemic that has shown no sign of relenting!) 

Tomorrow’s CPI report will be closely watched, but it is clear that the market is coming around to expect more inflation – and higher rates for longer – and that is weighing on stock and bond prices.  It is much the same scenario as markets faced in 2022.   

To a certain extent, higher interest rates have been good for savers.  It is great that we can earn money again on CDs and savings accounts.  But you can have too much of a good thing.  When rates increased from near 0 to over 4% in 2022 - markets shuddered, but ultimately recovered.  After all, today’s rates seem high in comparison to the rates of the early 2010s, but really aren’t all that high historically.  A move higher from here though – that is likely more than the economy can withstand.  

This latest round of rate increases isn’t much of a surprise to me.  I’ve been writing about the stickiness of inflation and impact of runaway deficit spending for quite some time.  This is why I’ve tried to limit my exposure to longer term bonds in portfolios and held more money in CDs, short term bonds, managed futures and similar investments that are not as exposed to, or can even benefit from, higher rates.  That may have slowed performance a bit during the recent runup in stock prices – but it served clients well in 2022 and I think is a good position to be in today. 

Now, I don’t want to suggest that stocks and bonds aren’t ALSO important.  Stocks have long been the engine of portfolio growth, and even for retirees can generate substantial and growing income from dividends, etc.  And as for bonds, even though they’ve had an awful last few years - at some point in the future the economy will slow, we may ultimately get the recession all the economists were predicting in 2022 – and if that happens rates will likely fall.  And when THAT happens, investors will do well to be in those longer term bonds that have been such a drag since 2021.  As always, it is pretty easy to predict these things will happen – what is dang near impossible is to predict WHEN.  It has been widely reported that all those predicting recession in 2022 were just wrong – but it may just be that their timing was off! 

The point is that in this uncertain environment, it is crucial to effectively manage risk and to be aware of and be prepared for multiple possible outcomes.  If you are young and have 10 or more years to retirement – just keep socking away the money in stocks.  Any downturn for you is a buying opportunity!   But if you are nearing or in retirement – understanding your risk exposure is crucial.  And as we clearly saw in 2022, just adding bonds to a portfolio may not be enough, especially in a rising rate environment!  Short term bonds, money markets and CDs, floating rate bonds, managed futures, fixed or equity indexed annuities (low cost no load only!) – all of these can maintain value or even grow, even when stocks and bonds are both suffering from higher rates.  Since we don’t know what is going to happen or when, an “all of the above” approach is usually the best bet.    

If you are unsure about your current strategy or your own portfolio risk exposures, you can always schedule an appointment with me to do a review.  You can schedule directly on my calendar at www.calendly.com/financialpathways