You may have noticed that the market has not been off to a great start this year. The S&P 500 index is down almost 9% year to date as of January 27th. The explanations for this are varied and include everything from supply chain issues to increased inflation. One of the oft-cited reasons for the downturn in the markets is the potential for “the Fed” to raise interest rates this year. This brings up a few key questions such as who is “the Fed”, why are they raising interest rates, and how does that effect the market?
In short, the Federal Reserve System, or simply the Fed, is the central bank and monetary authority of the United States . The role of the Fed is to keep our nation’s monetary and financial system safe and stable. The Federal Reserve System consists of 12 regional Federal Reserve Banks that are each responsible for a specific area of the country. These banks work together to maximize employment, keep prices stable, and to moderate the long-term interest rate level. In addition to the 12 regional banks, there is also a board of governors that are nominated by the President and approved by the senate. The board of governors is responsible for setting the reserve requirements and discount rate for banks nationwide. The reserve requirement is the percentage of deposits that a bank is required to hold in cash at any given time. The discount rate is the interest rate at which a bank can take a loan from the Fed. The board of governors also plays a key role in the Federal Open Market Committee or FOMC. It is the role of the FOMC to conduct “open market operations” which include the buying and selling of government securities and making adjustments to interest rates.
Now we get to the question, when and why does the Fed raise interest rates? In keeping with the Fed’s mandate to moderate long-term interest rates, this is a very important job. To understand why the Fed raises rates, we need to look at the other roles of the Fed, namely maximizing employment and stabilizing the monetary supply and financial system. Specifically, we should consider what is perhaps one of the greatest threats to those systems: inflation. There are different reasons for inflation but the type that our country is experiencing now can best be described as “too many dollars chasing too few goods”. Essentially, demand for goods and services in America exceeds the amount of goods and services available i.e. demand is great than supply. As a result, we see prices on consumer goods and services rise which in effect makes each dollar that you own less valuable than it was before.
The goal of the Fed is to target a constant rate of inflation of 2% as long-term this has been shown to help keep the nation economically stable. For context, the current inflation rate in the U.S., as measured by the Consumer Price Index (CPI), is 7.04% as of 1/27/2022. It is in times like these that the Fed can use the tools in its toolbox to attempt to bring inflation in check. These tools include raising reserve requirements, buying back government securities and, you guessed it, raising interest rates. The effect of all three of these measures is to take money out of the market and thus decrease the amount of money chasing the goods and services available. For example, the interest rates on mortgage have been exceptionally low which means that many people have either bought new property or refinanced for a larger loan. When you raise interest rates, coupled with raising the reserve requirement, you put a damper on this activity.
Right now you may be thinking, “this all (vaguely) makes sense, Alex, but how does the interest rate on loans effect my investment portfolio?” That is a great question! Stock and bond (debt) prices have an inverse relationship. When the value of stocks rise, the price for bonds falls and vice versa. When interest rates rise, the value of new bonds issued in the market is greater than existing bonds simply because these new bonds pay a greater percentage of interest. Bonds are also generally considered less risky or volatile than stocks. Therefore, when bond prices rise, stocks prices need to adjust to compensate investors for the amount of excess risk that they are taking relative to the return they could have gotten by being in bonds. This causes stock prices to drop when interest rates go up.
We could go much deeper into this topic but for now, this is the general idea. So what does this mean for you? Should you get your money out of stocks? That depends entirely on your situation and is a conversation that you should have with your financial advisor if you have questions. There are a plethora of factors that go into choosing an asset allocation for your portfolio. Choosing one variable, rising interest rates, and basing your entire financial plan on it, is likely not very prudent. It is also worth mentioning that the Fed has yet to announce if or when they will be raising interest rates and by how much. Of course, should you have any questions, feel free to reach out and I will do my best to answer them!
Today’s song of the week is a reminder of the attitude that you should take to long-term investing even when the markets are scary! Enjoy!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.