Living With Low Interest Rates
Low interest rates are great for borrowers, but not for savers. What is a saver to do? Three things: Invest in instruments with short-term maturities, even though they don’t pay much, diversify your portfolio and wait until rates increase.
And rates will increase eventually. In recent congressional testimony, Federal Reserve Chairman Ben Bernanke acknowledged that these rates penalize savers, but labeled them temporary. “Savers collectively have to hold all of the assets in the economy,” he said, “and a strong economy produces better returns in general.”
Translation: Spread your investments around, and when the economy strengthens, rates will rise. Bernanke makes sense. My firm thinks it wise to participate in the upward swing in the stock market, which we’ve seen over the past few years, while still harboring adequate reserves within lower yielding and more conservative asset classes.
Interest rates have nowhere to go but up. When they do, a heavier weighting in short duration bonds is the smartest play. By mostly holding bonds with shorter maturities, you sacrifice a little yield for protection against a price slump.
Bond prices are inversely related to bond yields. So as rates rise, bond prices drop. If an investor buys a bond that matures in 20 years, its market price might fall significantly when rates rise. That is a risk to avoid.
Another way of hedging against rising interest rates is by buying floating rate bond and bank loan funds. They also carry short maturities but include variable interest rates that float up or down with market conditions. Step-up government agency bonds offer fixed rates that may increase at regular intervals until maturity.
Finally, think about allocating a smaller portion of your bond portfolios to high-yield bonds. These are riskier than investment grade bonds, but provide a higher yield to investors to compensate for this added risk. Many of these so-called junk bonds yield around 6%, which is four percentage points more than a 10-year Treasury.
From 2009 through 2011, Bernanke and the Fed implemented unconventional and expansionary methods to recapitalize the banks as the economy sagged further, and in so doing, drastically increased the size of the Federal Reserve’s balance sheet to over $2.5 trillion in total assets. Most of this surge was the product of the Fed’s controversial program labeled “quantitative easing,” which was conducted in two waves. The Fed has alluded to the possibility of a third.
With easing, the Fed essentially creates or “prints” money to distribute to the banks to stimulate lending, and in turn, the banks sell their unwanted assets to the Fed. The predominant concern with this strategy is that artificially creating money sometimes results in hyperinflation down the road.
However, what the Fed has been confronting first has been the equally vicious cycle of deflation as banks continue to hoard cash, remaining fearful with foreclosures abounding, and home prices declining. Inflation is obviously a future concern for the Fed with its bloated balance sheet, but it is currently forced to handle one problem at a time.
Many Republican politicians argue that the Fed has become the embodiment of big government and call for a reduction of its regulatory powers and size. Meanwhile, Democrats accuse the Fed of caving to bailout demands from big financial institutions and for failing to protect consumers from complex and toxic financial products. Some critics demand Bernanke flood the banking system with even more credit. Others, worried about inflation, disparage his policy of near-zero rates and quantitative easing.
Ultimately, I think the argument is healthy. Remember, former Chairman Alan Greenspan had nary a detractor when he left the Fed in 2006. At the time, nobody dared challenge his advocacy of financial deregulation -- policies that even Greenspan has since partially stepped back from.
Regardless of where you stand on the debate, what cannot be overlooked is that the Panic of 2008 was the single biggest threat to American capitalism since the Great Depression. Thanks in large part to the actions of Chairman Bernanke and the Fed, our economy narrowly avoided collapse. It is obviously unpleasant to compare the Depression and the 2008 financial crisis when seeking to defend current Fed policy. But the Depression is perhaps the only other period in U.S. history when our banking system and credit markets suffered such paralyzing damage.
During the Depression, real gross domestic product (GDP) fell 36% and unemployment was 25%. In contrast, during our more recent Great Recession, GDP decreased by 3.7% and unemployment stayed just under 10%. So our current Fed monetary policy appears to be working.
I think John Steinbeck, with his Depression era novel The Grapes of Wrath, captured it best when he wrote: “This you may say of humans—when theories change and crash, when schools, philosophies, when narrow dark alleys of thought, national, religious, economic, grow and disintegrate; humans reach, stumble forward, painfully, mistakenly sometimes. Having stepped forward, they may slip back, but only half a step, never the full step back.”
Four years after our painful step back, our economy lumbers forward, scarred yet undaunted, and for better or worse, with the Fed serving as life preserver for the free market.
Mike Sullivan is a financial planner with GHP Investment Advisors Inc. in Denver, Colo.
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