How Fed Rate Changes Can Impact Investing Decisions
The recent turbulence has presented new challenges for stock investors, as global financial markets are enduring significant turmoil.
As I write this column, the Fed's annual Economic Policy Symposium in Jackson Hole, Wyoming, is just days away. This event, organized by the Federal Reserve Bank of Kansas City, brings together academic experts, financial market participants and many of the world's central bankers. Although "Inflation Dynamics and Monetary Policy" is this year's official focus, it should be an opportunity to also discuss the challenges facing the global economy. Of particular importance currently is the slowdown in the emerging world and the threat it presents to overall social well-being and financial stability. I encourage readers to read summaries of that meeting as a supplement to this article, since the results may give important clues to near-term interest rate policy changes by the Fed.
The recent turbulence has presented new challenges for stock investors, as global financial markets are enduring significant turmoil. This rampant volatility was ignited by the nearly 30% decline in Chinese stock markets in only three days. The huge decline has spilled into global markets, including the US, where we had a record one-day decline of 1,000 points in the Dow Jones Industrial Average. While economists and financial market specialists will debate for years to come the "reasons" for this most recent declines, all reasonable explanations will likely point to interest rates as a component. They may also present a solution.
China presents an interesting case study. The Chinese government runs their central bank quite differently from the US. In the US, the Fed Board of Governors and the heads of the regional Federal Reserve Banks are all involved in debate and decision-making on interest rate policy. While we may not always have the best results from Fed policy decisions, we at least know their process and procedure for making decisions. The Chinese central bank is the Peoples' Bank of China (PBoC), but senior Communist Party officials outside the central bank approve key decisions such as changes to the benchmark interest rate. Their decisions at times seem to come with no warning and don't always complement decisions by other nations' central banks made around the same time. A prime example is the lack of interest rate decision-making by PBoC in the summer of 2015, followed by the surprise interest rate reduction announced on August 25, 2015. These decisions seemed to exacerbate already volatile global markets.
The recent history of the US is another telling example of the impact of interest rate decisions. When the housing crisis hit in 2007, the economy was stabilized in part by the Fed dropping interest rates at an unprecedented rate. In a few short months, we arrived at a near zero Fed funds rate, much lower mortgage rates, and savings rates that are now almost comical to read. Recently, a bank advertised in a full-page newspaper ad that they're "Now Offering 0.25% on 90-day CDs to our Best Customers!" I would hate to see what they offered the "worst" customers.
One major impact of the Fed policy to lower rates was that many people living on fixed incomes (often hurt by interest from bank CDs) were suddenly thrust into drastic cash flow cuts as rates declined. Many of these people turned to the stock market or alternative investments offering higher returns than the banks. Thus, the Fed interest rate policy directly impacted the investment decisions of millions of Americans.
Things initially worked out, as the stock market embarked on an upward journey for the next several years. However, by the beginning of 2014 the economy started to slow dramatically, as measured by employment numbers and gross domestic product (GDP) figures. The Fed, which already had rates near zero, chose to undertake a policy called Quantitative Easing. This policy saw the Fed enter the government bond market and purchase billions of dollars' worth of US government bonds. Their purchases caused interest rates across the entire debt market to decline, as the rates on government bonds fell due to the massive Fed purchases of bonds. Since mortgage rates, corporate debt rates, and even consumer debt rates are directly impacted by bond rates, those rates also began to decline.
Of course when money is cheap (interest rates are low), that encourages borrowing for many things, including the purchase of investments like stocks and real estate. The problem is that when the interest rates start to rise again, the cost to carry all investments with borrowed money begins to rise. As a result, investors start to sell the investments bought with borrowed money (leveraged investments). As the market declines, that triggers more and more selling as many more investors see their cost of carrying the investments (borrowed money) start to rise rapidly. This phenomenon expands day-by-day—as it did in China the first few weeks of August—and eventually we tend to see panic selling as all the leveraged investors “head for the exits” at the same time.
In recent weeks, the Fed has indicated that it may start to raise rates—even very slightly—as soon as September 2015. This news yet again shook the market as investors started to realize their costs could rise substantially with higher rates. Accordingly, this fear started the stampede for the exits as investors sold shares in an effort to get back into cash. There has already been so much worry and apprehension that the Fed has now indicated they may not raise rates until the first quarter of 2016.
Since the evidence is very strong that Fed interest rate policies have a direct impact on the economy—particularly the housing and stock markets—it becomes even more important to seek professional assistance in managing your finances. Whether it be stock market investments for retirement, college funding programs, or the purchase of a new home, a team like that at BCU Investment Advisors available through CUSO Financial Services, L.P.* has the experience to help you understand the impact of Fed policy decisions and make the most of your financial planning.
*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. The credit union has contracted with CFS to make non-deposit investment products and services available to credit union members.
Article was written by Patrick Catania