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The Siren Call of Higher Interest Rates

The Siren Call of Higher Interest Rates

March 21, 2023

The Siren Call of Higher Interest Rates

I was reading online chatter attached to a financial self help article and found what appears to be a consensus that the best investment strategy for today is to sell everything and put it all in short term Treasuries.  After all, the logic goes, you can get over 4% now with 0 risk of loss.  Whatever could be wrong with that?

There is no doubt that short term interest rates on ultra safe bonds and CDs, even some money market funds, is hugely appealing.   I have increased the “cash” allocation in client portfolios substantially – from less than 1% to as much as 10% or more in some cases.  So you might ask, why not go “all in” and ditch the uncertainty associated with stocks? 

The answer is that, while these returns seem attractive in the short run, these high yielding short run investments are subject to 3 major flaws when you think out beyond a few months. 

First, the rates may not last.  If the economy slows substantially, or we enter a recession, interest rates will fall.  Let’s say the recession is a severe one, and interest rates fall all the way back to 1%.  That 18 month CD you bought a few months ago will mature next spring and you will be faced with the question of “what do I do now?”  Sure, now you can reinvest back into longer term bonds, or stocks – but we can be almost certain that long term bonds will be expensive (bond prices would soar as interest rates fell) and stocks may have also become expensive.  This is what we investment pros refer to as “reinvestment risk,” and it is a significant risk when investing in short term instruments such as this. 

Second, if rates DO remain high, it means that inflation has stayed high.  We have seen that stocks were negatively impacted by the rising interest rates brought on by inflation over the past year.  However, when inflation remains stubbornly high for a longer period of time, stocks tend to do a much better job of keeping up with the cost of living.  Even now, we know that these 4% rates may sound attractive, but with inflation running at 6% you are still losing money in terms of purchasing power of your nest egg.  “OK,” you may say, “but I’m still doing better than stocks over the past 12 months!”.  True enough. But for over 100 years, despite these periods of instability, stocks have consistently provided a return of about 7% over the rate of inflation.  Short term treasuries, T bills, and CDs at their very best struggle to just keep pace with inflation. 

Third, unlike longer term bonds, short term fixed income has only modest diversification value.  I can just hear the scoffing amongst my readers at that statement.  And I get it.  Bonds utterly failed as a diversification tool in 2022.  Stocks fell by 20% for the year and bonds were down 18% - some diversification THAT is!   But with interest rates now much higher, and with the threat of a recession on the horizon, longer term bonds are looking much sweeter!  If the economy falls, inflation will come down.  As inflation comes down and the economy sputters, the Fed will shift from fighting inflation to stimulating the economy by cutting rates.  As interest rates fall, bonds will increase in value.  In this scenario, stocks may be falling (due to the recession) but bonds will be rising.  Yes, the money in short term CDs and money markets will be safe, but it will not be increasing in value as would bonds. 

In summary, there are several possible economic futures, each one of which results in a different “winner” in a diversified portfolio – and we can’t know which one will be realized. 

Scenario one.  Economy stalls, we have a recession, inflation falls, interest rates fall.  Long term bonds will be up dramatically.  Short term bonds will mature and reinvest at dramatically lower rates.  Stocks will fall initially, then recover as the recession nears its peak.  Traditional bonds win. 

Scenario two.  Economy slows but avoids recession while inflation falls.  Interest rates stable or fall slightly.  Stocks will do well as fears of recession fade.  Long term bonds will move somewhat higher.  Short term bonds will reinvest at somewhat lower rates.  Stocks win. 

Scenario three.  Economy stays hot, and inflation remains stubborn.  Traditional bonds may suffer more losses if rates rise further.  If interest rate increases are modest, stocks may do well, but if rates soar, stocks may lose value.  Short term (CDs and money markets) may be the winner in this scenario as they may be able to reinvest at even higher rates – but of course, moving forward from there – the three scenarios will repeat themselves. 

At no point will we EVER be able to predict what the future holds, and thus which part of the investment mix will be best during the next few months or year.  This is why, even though I have found these short term rates very appealing – for what they are – I won’t go “all in” and abandon everything else.  Short term bonds, CDs and T-bills are a helpful part of a robust asset allocation – but they have a specific role to play in that allocation.  So although the “high short term interest rate” basket looks appealing amidst market turmoil, it still doesn’t make sense to put all of your eggs in it.