Given that the Fed will continue to be in the news, here is a framework of questions to ask when it is making headlines.
What do we know?
- On July 27th, the Federal Reserve raised the federal-funds rate by 75 basis points. This was part of what the central bank said would be a series of rate increases to combat inflation.
- Given that interest rates have been and likely will be an ongoing topic of conversation, it’s probably helpful to define some of the terms that are often referenced.
- The federal funds target rate is the rate (or range) set by members of the Federal Open Market Committee (FOMC), part of the Federal Reserve System. The effective federal funds rate is the interest rate at which depository institutions lend balances at the US Federal Reserve to other depository institutions overnight. The FOMC holds eight regularly scheduled meetings per year to set the target rate, and attempts to influence the effective rate towards the target through open market operations.
- If you are tired of hearing about the Fed, the bad news is that this is not the last you’ll hear of Mr. Powell. The Fed meets again at the end of September. The good news is that you don’t have to have your eyes glued to screens in search of the latest updates to have a worthwhile investment experience.
Is this new information?
- For weeks ahead of the official announcement, analysts and economists were working to predict what the magic number would be. From their point of view, it was not a question of if there would be an increase but rather how large it would be.
- Many forecasters had already concluded it would rise by 0.75%.1 Those who thought it would be higher or lower incorporated their view into their trading decisions.
- Similarly in June, we saw the yield curve adjust days before the official announcement. Columnists and pundits are already discussing what rates will look like by the end of next year. They look at inputs such as inflation and jobs reports, among others. While no one can predict the future, investors across the world are continuously forming expectations and incorporating them into prices every day.
What does this mean for bonds?
- Forward rates and interest rate changes impact the returns of bonds. Typically, higher future inflation and interest rates make current bonds less attractive, causing their price to decrease.
- Dimensional’s research found no reliable relations between past changes in the federal funds rate and future bond returns or future term premiums.2 In other words, moving to cash or shortening duration in response to changes in the federal funds rate is unlikely to lead to better investment outcomes.
- While seeing negative performance on bonds is frustrating, rates are more attractive now, which can be positive for future returns and reinvestment. Moving from a low-rate environment to a high one can be painful, but we have seen it benefit investors in the long run.
- Diversification across maturities, issuers, and currencies of issuance may also reduce the impact of rising interest rates in a given market.
- Fortunately, today’s yield curve contains valuable information about expected returns. A systematic strategy that dynamically varies its duration, credit and currency allocation based on current yield curves is a robust way to target higher expected returns in fixed income.
What does this mean for stocks?
- Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor stock market performance. However, equity returns in the US have been positive on average following hikes in the fed funds rate. (Surprisingly Benign: How Stocks Respond to Hikes in Fed Funds Rate)
- Dimensional’s research shows there has not been a strong relation between interest rate levels or interest rate changes and the equity, size, value, or profitability premiums in the historical data.
- The chart below presents annualized US equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. Reassuringly, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.3
Should I make a change?
- Investors have been thinking about the rate hike long before the official announcement. They have been buying and selling based on their expectations.
- Increases in interest rates tend to decrease the price of bonds; but that does not mean you need to move to cash. Attractive rates moving forward, diversification, and a systematic approach to implementation can add value to a portfolio with bonds.
- Regardless of Fed announcements, stocks have delivered strong longer-term performance on average.
- Unless you have had a change in goals or circumstances, trying to time the market around Fed activity may lead to unnecessary stress and risk to your investment experience.
Past performance is not a guarantee of future results. Source: Monthly target federal funds rate data from Federal Reserve Bank of St. Louis. The monthly series reflects the federal funds target rate from January 1983 through December 2008 and the federal funds target range—upper limit (ul) from January 2009 through December 2021. Equity market returns computed using monthly return to the Fama/French Total US Market Research Index, available from Ken French Data Library. There are 70 one-month rate hikes, 28 two-month rate hikes, and 389 months without an increase. Average annualized returns following consecutive rate increases starting at month end; performance time horizons can overlap.