Rising Interest Rate Jitters - By Lewis J. Walker, CFP(R)

It’s the guessing game of the summer. When will the Federal Reserve Bank raise its federal-funds target rate from the 0% to 0.25% floor where it has stayed since December 2008? Low interest rates have persisted since the financial crisis as the Fed primed our slower-than-average recovery with easy money. With early August reports of steady job gains, speculation is rising that the Fed may increase interest rates, possibly as early as September. What might that mean to you as an investor or borrower?

The Fed funds rate is what banks are charged to borrow funds overnight from the Federal Reserve Bank to meet reserve requirements. Banks apply the Fed funds rate in determining all other short-term interest rates. In essence, our central bank may increase the cost of money, impacting the prime lending rate (currently 3.5%), and rates charged on bank loans, credit cards, and adjustable-rate mortgages. It also influences the rates paid on savings and checking account deposits. Longer term interest rates are indirectly influenced as rising short-term rates pressure the long end of the interest rate curve.

The current rate is as low as the Fed funds rate can go. Toward the end of the “stagflationary” 1970s, Fed Chairman Paul Volcker in 1979 hiked the Fed funds rate to 20% to fight inflation. The prime rate peaked at 21.50%, an all-time high from December 19, 1980 through January 2, 1981. We are not likely to see anything like that any time soon! Far from it.

Normally the Fed increases the cost of money to tame inflation. This time the call is for “normalization,” the idea that abnormally low interest rates are distorting the economy and it’s time to “get back to normal,” restoring market forces and easing “easy money.” Essentially “free money” spurs risk taking and the potentially unwise use of leverage. Conservative savers are penalized by yields that in many cases are negative adjusted for inflation and taxes.

Rising interest rates pressure fixed income investments as bond prices in general move inversely to increases or decreases in interest rates. The so- called “bond vigilantes” watch the yields on 2-year and 10-year Treasury paper, in particular. On 8/8/15 2-year notes sported a yield of 0.72%; 10-year notes, 2.16%.

Speculation centers around a potential 25 basis point (0.25%) increase in the Fed funds rate. However, there is little potential for rates in general to shoot higher. Inflation continues below the Fed’s target rate of 2%. The trailing one-year “core inflation rate” is running at 1.8%, with “all items” inflation far less than that. Yes, core inflation numbers omit food and energy, and while gas prices are tamer, drug and tuition prices and a few other things you use are rising in price, but we are talking “government statisticians” who live in an alternate universe. Gold as an inflation hedge is tarnished, having dropped from a high topping $1900 an ounce in August 2011 to $1094 an ounce on August 8, 2015. Depressed gold prices signal expectations of low inflation and a strong dollar.

The municipal bond traders at Belle Haven Investments in Rye Brook, NY, note 17 developed nations with 10- year yields on government paper lower than America’s. Eight nations offer yields less than 1%, making U.S. yields over 2% along with a strong credit rating relatively attractive, spurring dollar strength. The strong dollar is a bonanza for tourists headed abroad but Mr. Market is not enthusiastic. Some 30% to 35% of S&P 500 corporate revenues come from overseas and the bulked up greenback makes our products less competitive in world markets. Plus domestic firms have to compete against cheaper imports, pressuring profit margins.

Janet Yellen may raise rates slightly, throwing a bone to the normalization crowd. But all-in-all, deflationary pressures, lower rates abroad, and threats from a strong dollar do not portend sustained and significant interest rate hikes. In our view, stock and bond willies assume a case worse than reality. Plus, stock traders may see a small rise as a signal the economic fundamentals are stronger in the Fed’s eyes. On Wall Street, a negative can become a positive in an instant!

Lewis Walker is President of Walker Capital Management, LLC. Certain advisory services are offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker and Mike Hostetler are registered representatives of SFA which is otherwise unaffiliated with Walker Capital Management, LLC. lewisw@theinvestmentcoach.com