By: Jerry Nix | Freewavemaker, LLC
Date Published: September 22, 2023
The Fed is at it again …
Below are excerpts from a daily email I get from Zacks Investment Research and I want to give the writer, Kevin Matras, acknowledgment for these words of wisdom:
Stocks closed lower yesterday after the Fed announcement on rates, and the Fed Chairman’s press conference.
Stocks were up for most of the day before the FOMC announcement. But afterwards, when the Fed announced they would hold rates steady, as expected, the markets turned negative.
And that was because it was noted that 12 out of 19 committee members (63%) still expect one more rate hike by the end of the year, which means at November’s or December’s meeting.
Moreover, they estimated the Fed Funds rate for this year at 5.6% (which would indeed mean one more 25 basis point rate hike); they raised their target for next year to 5.1% from their previous estimate of 4.6% (which means they expect to cut interest rates less than they previously expected); and they put it at 3.9% for the end of 2025.
They also upgraded their language on economic growth changing it from ‘moderate’ to ‘solid.’ They now see full-year GDP coming in at 2.1% for this year vs. their previous estimate of 1.0%, and then slipping to 1.5% for 2024.
But they still don’t expect to hit their goal of 2% inflation this year as they predict PCE inflation will finish at 3.3% this year, and 2.5% next year. So, the Fed’s target of 2% inflation is not expected to be achieved until 2025. Hence the higher rates for longer.
Why does the stock market decline when the Fed raises interest rates?
There are a few reasons why the stock market tends to decline when the Fed raises interest rates:
- Higher borrowing costs. When interest rates rise, it becomes more expensive for businesses to borrow money. This can lead to lower investment and slower economic growth, which can hurt corporate profits and stock prices.
- Reduced present value of future earnings. Investors use a discount rate to calculate the present value of future earnings when valuing stocks. A higher discount rate lowers the present value of future earnings, which can lead to lower stock prices.
- Increased competition from bonds. When interest rates rise, bonds become more attractive investments. This is because bonds offer a guaranteed return, while stocks do not. As a result, some investors may sell stocks and buy bonds, which can lead to a decline in the stock market.
- Investor sentiment. When the Fed raises interest rates, it is often a sign that the economy is slowing down. This can make investors nervous and lead them to sell stocks.
It is important to note that the relationship between interest rates and the stock market is complex and not always straightforward. For example, if the Fed raises interest rates because the economy is growing strongly, the stock market may continue to rise. Additionally, the stock market may decline for reasons other than interest rate changes, such as geopolitical tensions or corporate scandals.
In the current environment, the Fed is raising interest rates in order to combat inflation. This has led to some concerns that the stock market could decline further. However, it is important to remember that the stock market is a long-term investment. Investors who are focused on their long-term goals should not panic sell if the market declines in the short term.
Where does much of this money that leaves the stock market go?
Much of it goes directly into Bonds or Notes offered by the U.S. Government. People do this because the feel they can get a solid return without much of a potential loss.
Those rates as of the date of this writing can be seen as follows:
MATURITY OF BOND OR NOTE
|INTEREST RATE NOW|
Notice that the shorter-term instruments are paying more than the longer-term instruments. This is because we are currently in a period of inverted yield curves. It should also be noted that these interest rate yields are on newly issued bonds and notes only. The interest rate return on existing bonds or notes may be higher or lower.
An inverted yield curve is a situation in which short-term interest rates are higher than long-term interest rates. This is unusual, as long-term interest rates are typically higher than short-term interest rates to compensate investors for the additional risk of tying up their money for a longer period of time.
There are a few reasons why an inverted yield curve might occur:
- Expectations of a recession. Investors may expect interest rates to fall in the future, either because they believe the economy is heading for a recession or because they believe the central bank will cut interest rates to stimulate the economy. As a result, they may be willing to buy long-term bonds at lower yields.
- Demand for safe-haven assets. In times of economic uncertainty, investors may flock to safe-haven assets, such as long-term government bonds. This can drive up the prices of long-term bonds and push down their yields.
- Government policies. Governments may implement policies that drive up the demand for long-term bonds, such as quantitative easing programs. This can also lead to an inverted yield curve.
An inverted yield curve is often seen as a warning sign of a recession. However, it is important to note that an inverted yield curve does not always lead to a recession. For example, the yield curve inverted in 2019, but the US economy did not enter a recession until 2020.
As stated previously, the Fed is currently raising interest rates in an effort to combat inflation. This has led to an inverted yield curve in some parts of the curve, such as the 2-year/10-year spread. However, it is important to note that the yield curve is still upward-sloping overall, meaning that long-term interest rates are still higher than short-term interest rates on average.
Investors should carefully monitor the yield curve and other economic indicators to assess the risk of a recession.
So, what happens to existing bonds or notes when interest rates rise because of Fed actions?
The value will fall, just as though you owned a stock, but probably by not as much. For example:
If you buy a 2-year treasury note when interest rates are at 4% and interest rates go to 5%, the value of your 2-year note will decline. This is because investors can now buy new 2-year treasury notes with a higher yield, making your existing note less attractive.
The amount by which the value of your note declines will depend on a few factors, including the remaining time to maturity on your note and the overall shape of the yield curve. However, as a general rule of thumb, the longer the time to maturity on a bond, the more sensitive it is to changes in interest rates.
Therefore, if you buy a 2-year treasury note with a 4% coupon rate and interest rates rise to 5%, the value of your note might decline by around 5%. This means that if you paid $10,000 for your note, it might be worth only $9,500 if you sold it immediately after interest rates rose.
It is important to note that the value of your note will not actually decline by 5% until you sell it. However, the theoretical value of your note will decline by 5%, and this will make it more difficult to sell your note at a good price.
If you hold your note to maturity, you will still receive all of the scheduled interest payments and the full principal amount of the note. However, you will have missed out on the opportunity to invest your money in a new 2-year treasury note with a higher yield.
The gosh darned media …
The media seems to talk about the value of stocks declining as interest rates rise but very seldom, if ever, talk about the value of bonds and notes declining as interest rates rise. Why is this the case?
There are a few reasons why the media seems to talk about the value of stocks declining as interest rates rise but very seldom, if ever, talk about the value of bonds and notes declining as interest rates rise:
- Stocks are more popular than bonds. Stocks are generally seen as a riskier investment than bonds, but they also have the potential for higher returns. As a result, stocks are more popular among investors, and the media tends to focus more on the stock market.
- Stock prices are more volatile. Stock prices are more volatile than bond prices, meaning that they can fluctuate more wildly. This makes stock prices more interesting to the media, as they can generate more headlines.
- Bonds are more complex. Bonds are more complex financial instruments than stocks. This makes it more difficult for the media to explain how bond prices are affected by changes in interest rates.
In addition to these factors, it is also worth noting that the media tends to focus on negative news more than positive news. As a result, the media is more likely to report on the potential for stock prices to decline when interest rates rise than on the potential for bond prices to decline.
It is important to note that the value of bonds and notes does decline when interest rates rise. However, the decline in bond prices is typically less severe than the decline in stock prices. This is because bonds offer a guaranteed return, while stocks do not. As a result, investors are less likely to sell their bonds when interest rates rise.
It is also important to note that not ALL stocks will decline when interest rates rise, though many do. Some stocks have been rising all year long even with the increase of interest rates.
If you are considering investing in bonds, it is important to understand how interest rates can affect bond prices.
This table found on financialsignstudio.com will give you a good example:
And nothing could be much simpler to understand than this little teeter-totter drawing I found on financialadvisorsnetwork.net:
So, when and if interest rates start to fall soon, should investors sell their bonds and perhaps purchase more stock?
Whether or not it is a good idea for bondholders to sell their bonds when interest rates start to fall depends on a number of factors, including their investment goals, risk tolerance, and time horizon.
On the one hand, when interest rates fall, bond prices rise. This means that bondholders who sell their bonds when interest rates start to fall can lock in a profit. Additionally, bondholders who sell their bonds can reinvest the proceeds in new bonds with higher yields.
On the other hand, bondholders who sell their bonds when interest rates start to fall may miss out on future capital appreciation. This is because bond prices are likely to continue to rise as interest rates fall. Additionally, bondholders who sell their bonds may have to pay transaction costs, which can reduce their profits.
Overall, the decision of whether or not to sell bonds when interest rates start to fall is a complex one. Bondholders should carefully consider their individual circumstances before making a decision.
Here are some things to consider when deciding whether or not to sell bonds when interest rates start to fall:
- Your investment goals. Are you looking to generate income, preserve capital, or grow your wealth? If you are looking to generate income, you may want to hold on to your bonds, even if interest rates fall. This is because bonds offer a guaranteed stream of interest payments. If you are looking to preserve capital or grow your wealth, you may want to consider selling your bonds and reinvesting the proceeds in other assets, such as stocks.
- Your risk tolerance. Bonds are generally considered to be a low-risk investment. However, all investments carry some risk. If you have a low risk tolerance, you may want to hold on to your bonds, even if interest rates fall. This is because bonds can provide stability to your portfolio. If you have a higher risk tolerance, you may be more comfortable with the risk of selling your bonds and reinvesting the proceeds in other assets.
- Your time horizon. If you are investing for the long term, you may be more comfortable with the risk of selling your bonds and reinvesting the proceeds in other assets. This is because you have more time to recover from any losses. If you are investing for the short term, you may want to hold on to your bonds to avoid the risk of losing money.
The Fed Chair …
Seems to have such an impact on the stock market I’ve often wondered why he/she is allowed to even talk during normal market hours.
There are a few reasons why the Fed Chair is allowed to talk during market hours, even though his speech can have such a potent impact on the markets:
- Transparency. The Fed believes that it is important to be transparent with the markets about its monetary policy decisions. This includes communicating with the public about its views on the economy and its plans for the future.
- Accountability. The Fed is accountable to the American people. By speaking publicly about its monetary policy decisions, the Fed allows the public to hold it accountable.
- Effectiveness. The Fed’s monetary policy decisions can have a significant impact on the economy. By communicating with the markets about its plans, the Fed can help to ensure that its decisions are as effective as possible.
Of course, the Fed is aware of the potential impact of its communication on the markets. That is why it is careful to avoid making any market-moving statements during its speeches. The Fed also tries to give the markets plenty of warning before making any major changes to its monetary policy.
Overall, the Fed believes that the benefits of transparency and accountability outweigh the risks of market volatility. However, the Fed is committed to communicating with the markets in a way that is clear, accurate, and responsible.
It is important to note that the Fed Chair is not the only person who is allowed to talk during market hours. Other government officials, such as the President and the Treasury Secretary, are also allowed to speak publicly about economic matters. However, the Fed Chair is arguably the most influential speaker on economic matters, as the Fed is responsible for setting monetary policy.
Investors should be aware of the potential impact of Fed Chair speeches on the markets and should carefully consider the information that is presented before making any investment decisions.
If you are unsure of what to do, it is always a good idea to consult with a financial advisor. A financial advisor can help you to assess your individual circumstances and develop an investment strategy that is right for you. I am not a financial advisor since my retirement in June 2018.
Finally, the one thing I am learning as I learn to “day trade” is that I should probably take the day off on days that the Fed Chair is speaking. Lately, he has done nothing to spur the markets upward and a lot to drive them into the ground. But, I believe brighter days for all investors are just around the corner!
Have a great day!
Jerry Nix |Freewavemaker, LLC