The Fed will meet on December 15th and 16th and it is widely anticipated that they will announce a quarter percentage point increase in the Federal Funds rate. This interest rate is the rate the Fed sets and banks charge each other to borrow funds overnight. It’s a benchmark off which many other interest rates are formed.
This move has been widely anticipated and telegraphed by the Fed. Given the Federal Funds rate has been near zero since 2008 a move represents a large change in policy so their goal was to minimize market surprise. As a result an increase has been largely priced into yields and stock prices. Thus, we do not expect there to be a significant impact from the announcement.
After the announcement investors will quickly turn their attention to the speed and size of future interest rate increases. Again the Fed has preached that they will be moving at a measured pace. If they stay on this pace the rate increases won’t have that significant an impact on fixed income holdings. However, a departure from this is what will drive higher volatility and potentially more negative performance from bonds.
We continue to believe maintaining some allocation to a diversified portfolio of fixed income benefits most investors. While an increase in interest rates results in a decline in bond values, new bonds can be purchased at higher prevailing rates, so any decline in bond values are a temporary issue. The process of raising interest rates closer to historical norms ultimately is a good thing as it’s an indication the economy is strengthening.
While the Fed is likely to raise the Federal Funds rate later this month, we believe that the market has already priced this in and it is quite possible that other factors could prevent interest rates from rising substantially. However, if rates due rise, by having a shorter term portfolio that is broadly and internationally diversified an investor can help mitigate the short term effect rising rates have on a bond portfolio.
Index Performance Nov. YTD Trl 1Yr
US Stock (Russell 3000) 0.55% 2.58% 2.58%
Foreign Stock (FTSE AW ex US) -1.95% -2.79% -6.18%
Total US Bond Mkt. (BarCap Aggregate) -0.26% 0.88% 0.97%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) -0.29% 1.08% 0.76%
Municipal Bonds (BarCap 1-10yr Muni) 0.06% 2.10% 2.13%
Cash (ML 3Month T-Bill) 0.01% 0.02% 0.02%
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