What’s the ‘Fed’ up to? 3 ways to respond to recent actions by the Federal Reserve
By Lucas Aubin, Financial Planning Associate
No doubt you’ve seen and heard the “Fed” referenced in the news a lot lately. The Fed (short for Federal Reserve) is the central bank of the United States. Its primary purpose is supporting a healthy economy through monetary means. The Fed’s main goals are to attain maximum employment, stabilize prices and moderate interest rates. Interest rates can be an effective tool to regulate the economy when it needs a boost or when it needs to cool off.
Much of the current Fed activity is the result of actions taken during the pandemic, when the government flooded the economy with money and the Fed took short-term rates to near 0 percent in order to stave off an economic collapse. Now it is trying to do the opposite. With the current rate of inflation sitting at a level we haven’t seen in decades (8.6 percent at the time of this writing), the Fed has been raising interest rates to try and control inflation and “cool down” the economy.
Keep in mind that the Fed itself doesn’t raise interest rates in the way consumers tend to recognize (e.g. interest paid on your savings account, mortgage rates or credit card charges). Instead they have tools (primarily buying/selling bonds or changing the cost for other banks to borrow funds from the Fed overnight) that can spur interest rate changes across a variety of areas. But the reality is, the market determines interest rates. That market is ultimately the consumer and corporations determining how much are they willing to pay to borrow funds to buy things. Banks and other companies then set lending rates accordingly.
For the consumer, this rising interest rate environment means everything from mortgages to auto loans to credit cards may cost more. The type of debt will determine how sensitive it will be to rate changes. For example, mortgage rates have nearly doubled in the past year from 3 percent to nearly 6 percent. Even though the Fed has only raised overnight lending by about 1.50 percent, credit card interest rates are particularly vulnerable to Fed rate increases, as many of them have variable rates that go up as the Fed raises interest rates.
So what does all of this mean for you and your portfolio? Rising interest rates typically negatively impact 401(k) plans. Stocks also tend to decline as the cost of borrowing for those companies increases. Bond prices typically go down when interest rates go up. Unfortunately, just when we need bonds to hedge the stock market downturn, they don’t feel like they are working. But there is a light at the end of this cycle, and we have needed to get there for a long time.
A rising interest rate and high-inflation environment can certainly feel unnerving, but this is a very healthy phase for our portfolios in the long run. Once we get to the proverbial “light at the end of the tunnel,” we will finally have bonds that are paying more interest. That will mean you won’t have to take as much risk in your portfolio (usually stocks) to get similar returns. For stocks, the overly in debt companies will be found out quickly, and we will have better fundamentals to analyze. Stocks have “drunk the 0 percent Kool-Aid” for a decade. The next cycle will be all about your portfolio managers and stock selection.
So what do you do right now? There are things you can do with your advisor now to “weather the storm” and position yourself for the best possible outcome:
Take advantage of market volatility
Even in times of market turmoil, there is opportunity. Currently, we are seeing more opportunity in fixed income investments, including buying longer-term bonds. As a general rule, for every 1 percent increase in the Fed Funds rate, a bond’s value will change approximately 1 percent in the opposite direction for every year of the length of maturity. As we get further into this rate-hike cycle, certain maturities of bonds will keep losing value and others will start to level off. The bond funds that are leveling off would be a great area to buy into right now, as they can be bought at a depressed price. In addition, there is more yield in money markets right now, which can be a smart alternative to simply holding more cash.
For stocks, this is a great time to buy what you want to own in 12 months. The stock market is a forward-looking indicator and prices in the next 12 months (you won’t catch it once it takes off.) But don’t try to time it. Stay balanced and on plan. Additionally, this can also be an ideal time to convert a traditional IRA to a Roth IRA, considering some assets have decreased in value, which can provide significant tax advantages in the future. Always consult your tax advisor before doing so.
Revisit your financial and investment plan
Whenever the economy and markets are in flux, that’s the time to revisit your current strategy. What it’s not the time to do is make “knee-jerk” decisions based on emotions alone. Rather, ensure your plan reflects your current goals, time horizon and risk tolerance. Working with your advisor, thoughtfully explore areas in the current market that could bolster your plan. At CAISSA, we tranche our clients’ investments to ensure near-term needs are properly funded, and long-term aspirations are supported by appropriate investment strategies. Now is the time to revisit your plan strategically for future action.
‘Torpedo proof’ your plan
Financial plans are best developed during times of calm and market stability, but stability of course doesn’t last, which is what we are experiencing now. Therefore, in addition to revisiting and updating your plan, it is just as important to stress test, or as we way at CAISSA “torpedo proof,” your financial plan. That involves identifying how much you can spend per month and still achieve your overall goals within your time horizon, taking into account potentially lower rates of investment returns, debt paydown strategies and longevity (we estimate at what age a client can expect to run out of money with an accurate financial plan in place). The goal is to demonstrate that your financial plan is structured to stay on track and meet your goals amid an economic downturn.
The good news is that once the Fed goes through this interest rate-hiking cycle, many portfolios will be in a better place. While it may feel painful now, at CAISSA we believe there is light at the end of the tunnel. Having a qualified advisor in your corner to help make sure your plan is up to date and who seizes on the opportunities this market presents will no doubt help you sleep better at night.