With the headlines showing economic concerns at every turn in the road, the global economy is in a constant state of disarray. The US dollar is high, oil prices are low and several European countries, including Greece, and Italy fuel uncertainty with large outstanding debts.
All this insecurity leaves many worrying over how and when the Fed will adjust interest rates. Since the 2008 financial crisis, the U.S. interest rates have remained very low (down to .25%). Slow economic growth is to blame for these low rates – with the Fed indicating that they would not raise rates until unemployment has improved and the U.S. saw considerable economic growth. While unemployment numbers are showing positive signs, the economy still remains sluggish. Many believe that as the economy improves over the next several months, the Fed will increase the Fed Funds rate which hasn’t been changed since December 2008.
So what does this mean for the investor? If the rates go up, we would generally recommend the purchase of bonds with a shorter term or lessen exposure to long duration bond funds. The reasoning behind this seems pretty simple –for example, if a bond fund has a duration of five years, and interest rates rose 1%, the price of that fund would go down by 5%. So in this scenario, a shorter duration would seem more beneficial over the course of the bond’s maturity. (However, it is also important to remember that the investor will receive less return on a shorter term bond.) For the investor that is just putting funds into the US market, shorter term bonds may seem a safer bet since there is a good chance that interest rates will be going up over the coming months. But the equation gets a bit more complex when you consider the global economy.
You are probably aware of how globalization affects manufacturing. China, India and other low-cost countries boost their production by having significant cost differences between Europe and the US. The U.S. debt market is also affected by the global debt market. If a foreign investor has $1 million put into fixed income investments, should they invest in European or Japanese debt when the return is zero or even negative? Most likely they would consider buying U.S. debt where they can receive 2% on 10 year bonds. This scenario is happening all over the world. The US has a safe debt rating and interest rates are significantly higher here than anywhere else with the same debt rating. So, even if the Fed raises rates from .25% to .50%, bond fund prices could rise and yields fall because of the demand internationally.
Consider this –What does China do with all that money we give them for the products they make? Or, what does Saudi Arabia do with all the US oil money they have acquired? There is a worldwide demand for U.S. bonds, which means that bond fund prices might not fall as expected, but may actually be bid up (and yields fall because they are inversely related to price). Add to this the currency manipulation of many different countries and the entire scenario becomes even more convoluted.
With all of this uncertainty and confusion, you might be asking “What should an investor do?” Simply put, hire a trusted fee-only advisor to worry about the interest rate direction, strength of US currency, best way to position investments and to monitor anything that might affect your returns. Investors should never make a financial decision and then not monitor for changes – this is why you should work with a trusted expert who has your best interest in mind.
For more information on this growing concern, check out this recent blog post.