Fed Raises Interest Rates - What It Means And How Fed Policy Is Misinterpreted

In The News...

To my surprise, #3 came earlier than I expected.

The Federal Reserve raised interest rates for the third time since it began "normalizing" rates back in Dec. 2015. This latest rate increase was another quarter-point rise in the Federal Funds Rate, boosting it from 0.50% to 0.75%. Following 7 years where rates were essentially 0.00% the Fed has begun slowly increasing them. Here is a look at how historically the Fed Funds Rate was:

(source: Federal Reserve Bank of St. Louis)

I emphasize Fed Funds Rate because people err by ambiguously saying "rates" anytime they refer to Fed policy. It does not represent all interest rates. The Fed Funds Rate is the short-term lending rate set by the Fed, which big banks use to lend to one another. That target rate trickles down and ultimately steers the interest rates banks apply to savings accounts and short-term loans. But there are two pretty big misconceptions about Fed policy in relation to interest rates, which I detail in the Opinion section below.

The Fed has two jobs: Manage our money supply and manage inflation. Raising interest rates is one way the Fed strives to temper inflation. In textbook economics terms, the Fed will raise rates as the economy expands. This promotes steadiness and prevents economic overheating, or worse, market bubbles. In 2008 we saw the reverse, where the Fed aggressively lowered interest rates in order to encourage lending and borrowing at time when the economy needed it to stave off recession.

Few entities have a tougher job than the Fed. Amidst the NCAA Tournament games happening right now the Fed is like a referee, where doing a good job is defined by making the calls everyone expects while remaining largely unnoticed. The only difference is that even if the Fed makes what appear to be the right calls, such as whether to raise rates, it's popular to go back and blame Fed officials if the market does not respond as anticipated. The Fed has an immensely tough and thankless job.

In The Market...

The S&P 500 gained +0.2% last week. Let's look under the hood:

Most sectors were positive last week, yet the S&P 500 was up minimally as a whole. Bonds and dividend-heavy stocks fell leading up to the Fed announcement as it was presumed that interest rates would go up. Investors do not like owning bonds if they believe they can obtain a higher interest rate in the near future. The funny part is that investors jumped back into bonds and dividend stocks immediately after the Fed announced the rate hike at 11 a.m. last Wednesday.

There is meaningful context relating to how long-term interest rates react following Fed rate hikes. Below is a chart of the 10-year Treasury yield, which differs from the short-term Federal Funds rate, but is more relevant when talking investments. Notice how the 10-year Treasury yield reacted following the previous rate increases, in Dec. 2015 and Dec. 2016. The 10-year rate yield actually went down

(courtesy of StockCharts.com)

If history repeats itself, this would be the third-straight time that long-term rates fall after the Fed announces a rate hike. Is this another coincidence or more of a trend?

In Our Opinion...

There are two misconceptions about how long-term interest rates behave in light of Federal Reserve policy.

Misconception #1: Fed policy directly influences home mortgage rates.

All rates are not created equal. The Federal Funds Rate best compares to a 1-month U.S. Treasury bill. A typical 30-year mortgage rate is going to channel the rate movement of a 10-year U.S. Treasury bond. Here is how closely the 10-year Treasury yield and 30-year mortgage rate move in tandem:

(sources: Federal Reserve Bank of St. Louis, Freddie Mac)

The correlation between the two is undeniable. If you look closely, notice that while the average 30-year fixed mortgage rate has risen a bit since the Fed began raising rates in Dec. 2015, the rise has been pretty tame. In fact, mortgage rates actually fell for the better part of six months after the Fed raised rates for the first time in 2015, as shown on the prior chart of the 10-year Treasury yield. How can this be?

Misconception #2: Interest rates are set by the Federal Reserve and that's that.

Interest rates, namely long-term ones, are driven by investor demand for bonds. They are not set by some monetary overlord. The Fed has a hand in guiding short-term rates, but investors collectively determine whether long-term rates go up or down, as bonds are traded within the market and subject to those forces of supply & demand.

Here is how... Traditionally we think of buying a bond, earning its interest payment each year ("coupon rate") and receiving our full principal amount back at the end of the bond term (5 years, 10 years, etc). However, the bond market is more complicated than that. Bonds are traded every day in the market. As old bonds mature, new ones are offered through U.S. Treasury auctions, but not before being bought and sold along the way.

Let's suppose you buy a bond and the next day investor demand is weaker for the same type of bond you purchased. Weaker demand means your bond is now worth less than what you paid. The interest you earn remains constant because the coupon rate is fixed at the time of purchase, but the yield fluctuates over time. In this case, your yield goes up because the value of your bond went down.

(Fixed coupon interest payment) / (Lower bond value) = Higher interest rate yield

The opposite is true as well. This is why bond values and their interest rate yields move in opposite directions. If demand increases for your type of bond in the future, the value of the bond you own rises. This means you now have a lower yield. It's this type of ongoing supply & demand that drives long-term interest rates. The Fed plays a role, but investors truly determine whether rates rise or fall.

In Our Portfolios...

Stocks: No major changes last week, although we did tweak some positions in certain accounts where funds were recently added.

Bonds: We sold one of our high-yield bond funds (ANGL) within smaller accounts and accounts that previously held both high-yield positions we use (the other being HYG).

Q&A / Financial Planning...

Staying on theme, a couple people asked last week whether to lock in their mortgage rate before the Fed announcement. My feeling is always the same -- do not base the timing of your home purchase loan or refinance loan off of Fed policy or how you think rates will behave. Lock in the loan when you need it.

In the case of a refinance, if you can save money and the math all ties out, just lock it in rather than getting greedy. Pigs get fat and hogs get slaughtered. I do think rates will slowly rise over time but they won't spike overnight or in the course of weeks. Again, investor supply & demand should keep them in check.

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Have a great week!


Brian E Betz, CFP®