How to Cope With Interest Rate Uncertainty

After keeping short-term interest rates near zero for seven years beginning with the financial crisis, the Federal Reserve hiked rates repeatedly from December 2015 to last December to head off inflation from a strengthening economy. Now it has signaled rates will stay flat through this year, if not longer, and President Donald Trump is lobbying for another rate cut. Investors may be wondering what to do.

Interest rates affect almost all types of investments, pushing bond prices up or down, raising or lowering corporate borrowing costs and the value of earnings, making one asset more desirable compared to others.

But historical trends don’t always recur in real life — or not as quickly or dramatically as investors expect. So many experts caution against major surgery to the long-term portfolio.

[See: 6 Investing Podcasts Advisors Recommend.]

“Small investors shouldn’t make major portfolio changes right now,” says Nathan Yates, economics and finance adjunct professor at Southern New Hampshire University’s College of Online and Continuing Education. “It’s a good time to rebalance allocations [to fit the plan], but I don’t recommend significant adjustments.”

“Investors’ choices shouldn’t be driven too much by this change in events, as a well-diversified portfolio is the best answer to deal with changes in market risk,” says Scott Poore, director of investment solutions at B. Riley Wealth Management in Memphis Tennessee. He expects investors to do better with bonds of short rather than long maturities, and with blue-chip large-cap stocks.

The Federal Open Market Committee has the most control over very short-term rates, such as the Fed Funds rate that banks charge one another for overnight deposits, while long-term interest rates are governed by investment demand. But changes in short-term rates ripple through the markets because long-term rates are influenced by what investors expect short-term rates to be in the future.

When some short-term rates went higher than longer-term rates in March, it created an inverted yield curve that can forecast a recession, though few experts predict one as bad as the Great Recession a decade ago. Many say a modest slowdown in economic growth is more likely.

“Based on history and the underlying dynamics of the economy, a yield curve inversion is indeed a bad sign and something to watch,” says Brad McMillan, chief investment officer for Commonwealth Financial Network in Waltham, Massachusetts. “But it is not a sign of imminent doom. What we should take away from (March) is the idea that risks continue to rise, and bear watching, but that we very likely still have some time to prepare. Is this path set in stone, either way? Of course not.”

Rate changes by the central bank have the clearest effect on bonds. A hike can push bond prices down because investors prefer newer bonds that pay more, while falling rates make older, more generous bonds more attractive, driving their prices up. The Fed’s halt in hikes suggests the next change is more likely to be a cut that an increase, so investors should prepare for a falling rate environment, says Sam G. Huszczo, owner of SGH Wealth Management in Southfield Michigan.

[See: 8 Investing Do’s and Don’ts During Market Volatility.]

“Bond prices actually go down when interest rates go up,” Huszczo says. “With rates halting, this could give people more confidence to buy longer-maturing bonds because they will have a higher confidence that they will not be missing out on new higher interest rates.” Higher demand would push up bond prices.

From January 1966 through December 2016, long-term government bonds returned 6.4 percent a year when rates were being cut, 8.3 percent when Fed policy was neutral and 6.3 percent when rates were rising, according to Robert Johnson, professor of finance at Creighton University’s Heider College of Business and author of the 2015 book “Invest With the Fed.”

Stocks are affected by rate changes in various ways, some good, others not so much. As rising rates make new bonds more appealing, some investor money will shift from stocks to bonds, pressing down on stock prices.

On the other hand, low interest rates drive down borrowing costs, which can boost corporate earnings, which is good for stock prices. Also, lower rates make a given level of earnings and dividends more attractive, tending to push stock prices up.

This effect can be seen in the ratio of share prices to the past 12 months of earnings — the price-earnings ratio, or share price divided by 12 months earnings, and its inverse, the earnings yield, or earnings divided by price.

If a stock trades at $100 with earnings of $2.50, P/E is 40, earnings yield 2.5 percent. As yields on alternatives like bonds fall below 2.5 percent, that stock yield looks better and better, so investors will pay more for every dollar of earnings when interest rates are low. Falling rates are good for stocks.

“For stocks, the relationship between Fed policy and returns is a simple one,” Johnson says. “Stock returns have been highest when the Fed is pursuing expansive monetary policy — cutting rates — and lowest when pursuing a restrictive monetary policy, raising rates.”

When rates are flat, as they are now, returns are in between, Johnson says.

From January 1966 through December 2016, the S&P 500 returned 15.2 percent annually in expansive monetary conditions, 11.4 percent in indeterminate conditions, and 5.8 percent in restrictive conditions.

[See: 7 Investments to Make With Your Tax Refund.]

Rate changes also affect other financial concerns that matter to investors, such as credit costs for a mortgage and cars. If rates are going to come down in a year or two, this might not be the best time to lock into a new mortgage or other loan. Cash that might have been used for a down payment on a new home this spring might do better put to work in another investment or to reduce high-rate debts like credit cards.

Of course, nothing is guaranteed when it comes to the economy, monetary policy or investing. Instead of weakening, the economy could gather itself for another growth spurt, leading the Fed to raise rates rather than cut them.

“The four most dangerous words in the English language with respect to investments are ‘This time is different,'” Johnson says, recommending that investors stick with a long-term plan emphasizing stocks when they are young and building up bonds and cash as they age.

Playing short-term market shifts is too dangerous for ordinary investors, he says, but he adds that it always makes sense to minimize interest costs by paying down debt.

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