Ask The Financial Expert: What the Fed Rate Hike Means to You in the New Year
Each month, we book time with some of our company’s top financial brain power to answer questions about investing and your finances. This month we’re talking about the Fed’s move to raise the Federal Funds Rate by .25 percent and what it means going forward.
The following is an excerpt from our Ask the Financial Expert podcast (listen to the entire podcast below):
Mark: We have lift-off! The Fed has started to raise rates for the first time since 2006. As you’ll recall, that’s the same year that Barry Bonds broke the home run record. Ron and Brent, let’s talk a little bit about the effect of the Fed raising rates.
Ron: First, I have to quote what I heard some commentator say: “My goodness, this is the ‘Oh, it finally is going to happen’ trade”—meaning it’s been talked about so much and everybody’s been waiting so long for Fed lift-off, and it’s finally happened. I along with a lot of investors are breathing a bit of a sigh of relief. I think it is a good thing. I think the market would have had a very bad reaction if it hadn't happened because it’s a sign that there are some things that are going right from the economic point of view. But I think the Fed will be very, very modest going forward. We’ll see maybe a couple of rate increases. I don’t think they’re going to do it every time they meet in the next year. It’ll be slow, and it’ll probably result in about a hundred or so basis point increase on the short end.
Brent: I’d like to take a step back and not focus so much on what it actually means from a stock/bond perspective, but what it means from an overall perspective to our personal investors. When a central bank cuts rates, they’re effectively trying to push down the price of risk. So they want to prod you into actually going out and spending and investing and taking on risk, even when the economy looks bad. And that led to this forward guidance [in which] they made a promise that if things got bad, they would do more. And so that led to this weird kind of period where bad news was good news and good news was good news.
And so, we believe it’s going to cause volatility in the future for three reasons.
- As they pull back and the policy crutch moves away, the economy’s going to have to do better. And so, there’s going to be a debate over the next few months about whether or not the economy’s strong enough to handle the rates.
- In 2013, I penned a piece called “The Future Price of the Current Calm.” And what that meant was because the Fed was creating these artificial tail winds, people were pushing into asset classes they normally wouldn't invest in. So if you think about CD investors, they might have gone out and bought investment-grade bonds. The person who buys investment-grade bonds went out and bought high-yield bonds, and on down the path. And so, as the Fed removes these artificial tail winds, you’re going to see volatility, and maybe that’s what we’ve seen in the high-yield bond market over the past few weeks. And that will likely continue into the future.
- There’s one last promise the Fed is making, or the market is believing they’re making, which is that they’re going to raise rates gradually. Ron is a very smart guy, and his team does a very good job; and I think he may ultimately end up being right, with the hundred basis points and the 50 basis points on the long end. But the market has taken that for an extreme certainty, and it’s priced for that. I think we’re going to spend 2016 debating on the path, and that’s going to cause future volatility. So, Ron, I think the Fed’s going to have more to say and that volatility is going to stay.
Ron: Brent, I think you make a very good point about what happens now when the Fed turns the other way and starts to raise—that there’s going to again be a real market pricing of risk as opposed to the Fed pricing risk. And we all will welcome that because I think it will mean that we’re seeing true, appropriate return for different levels of risk.
Hear more from Ron and Mark in the “Ask the Financial Expert” podcast:
Do you have a question for our financial experts? Email it to us at: AskTheExpert@northwesternmutual.com
The opinions expressed are those of individual investment professionals as of the date stated on this article and are subject to change. This material does not constitute investment advice, is not intended as an endorsement of any specific investment or security and is not a prediction of what will happen in the markets.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates, and are not obligated to return the investor’s principal. Additionally, high yield bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. Bond and bond fund investors should carefully consider risks such as: interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.