Wednesday, December 21, 2016

Thoughts on Interest Rates

Hello all,

I recently completed two finance courses here at business school: Applied Fixed Income and Speculative Investments, and Global Asset Allocation and Advanced Investments.  Both of these courses were very well taught (and very challenging if I'm honest), but I'm glad I took them because I learned a lot and because a good amount of the course material was about interest rates and hedging interest rate moves, etc. which seems pretty applicable in today's investing environment.  So as a result I thought I would briefly comment on interest rates, since the Federal Reserve finally completed another (albeit small) interest rate increase.

To start, I read this from Vanguard's website yesterday (copied directly):

What we're watching
"Federal Reserve policymakers raised the federal funds rate by 0.25 basis point to a range between 0.50% and 0.75% at their December 13–14 meeting. This is the first time this year—and only the second time in more than a decade—the Fed has increased short-term rates. 

Why it's important
The Fed's decision, which was widely expected, reaffirms its confidence in the strength of the U.S. economy, which is in the midst of one of its longest expansions. The labor market is essentially at full employment, and inflation is on track to reaching the Fed's 2% target.

Based on its statement after its last meeting, and its latest projections, the Fed plans a "gradual" increase in rates over the next couple of years. It expects three quarter-percentage-point rate increases in 2017 and three each in 2018 and 2019 before the rate levels off at a long-run "normal" 3.0%.

Vanguard's stance
We're encouraged by the Fed's decision to begin the process of normalizing rates, which have been near zero since 2009. Vanguard's economists expect the federal funds rate to increase to 1.5% by the end of 2017, but remain below 2% through at least 2018. This is in line with the Fed's pursuit of "dovish" tightening.

Fed rate increases could bring short-term pain to bond investors (bond prices fall as rates rise). But higher rates can benefit long-term investors. By reinvesting earned income at higher rates, investors can help offset bond price declines with higher income returns.

Regardless of the direction of interest rates, it's prudent for investors to maintain a diversified portfolio with an asset allocation consistent with their long-term goals, risk tolerance, and time horizon."

Alright. Back to my commentary on this article and interest rates in general, and I'll # my comments, just for efficiency's sake:

1) All of the above statements from Vanguard seem pretty obvious if you've been watching the Fed lately, but I did find it interesting that there have only been two increases in MORE THAN A DECADE.  I knew it had been awhile, but 10 years seems an extremely long period for such infrequent, AND small, increases.  We've been in a bull market for over 7 years now.

2) To me, interest rate 'normalization' (ie going back to around a 4%~ or so long term rate, let's say 10Y treasury) is an extremely good sign.  For many reasons.  First, higher interest rates imply higher stock returns.  Bonds' yields will be higher....hence stock returns need to be higher in order to compete and maintain an appropriate risk premium.  This intuitively makes sense, and is good for both equity investors and also for investors looking for long term income via equity (...dividend investors) or any other asset.  My bottom line point - Unless you are looking to borrow money, higher interest rates are better for you. We should be happy. This of course, is checked against an appropriately (ideally small) managed level of inflation, but out of control inflation doesn't seem to be a real possibility at the moment.  Still, I tend to like inflation, which brings me to my next point.

3) I WANT inflation. Badly actually. Why, you ask? Well because inflation is incredible for my portfolio.  So yes, I would like higher inflation, which typically comes with correspondingly higher interest rates, which I expect to happen. So the next question perhaps is: how is inflation "incredible for your portfolio?"  Well, thankfully because of the ~$700,000 of mortgage debt I have.  All of that debt (which frankly is a lot) is all at fixed rate, long-term, low interest rate debt.  Higher inflation then makes the present value of this debt significantly lower as the dollars I pay back years from now (some even 29 years away, on my mortgages for example), is worth less and less as inflation goes up. So in essence my debt is being paid off for me with inflation.  That is my bottom line point - debt is cheaper and cheaper and cheaper as inflation erodes it away, without you having to do ANYTHING.   This will be AMAZINGLY powerful for those that have decided to lock in very low, fixed rate long-term debt.

4) My last point isn't directly about interest rates, but look at this graph below and you'll see they are also at least a part of the cause.  Perhaps Trump's victory too.  Anyway, as interest rates rise, investors will flee bonds and go more into equities...again the result is higher stock returns (albeit argued a different way than what was done above, but with the same outcome).  THIS IS WHY I DON'T THINK it makes sense to liquidate your whole portfolio, or a lot of it, by trying to time the market.  Invest on the way up, continue to invest, invest MORE on the way down. Always invest. :)  Anyway, check out the graph showing huge equity inflows. 

As you can see, equity inflows have been huge recently, especially post-election.  A lot of this is due to improved forecasts of economic growth, which leads to higher interest rates, and higher inflation, and higher stock returns, etc.  It's a beautiful thing.

Well, I hope that was helpful and I'd be very curious to hear your thoughts or questions on interest rates. Thanks for reading!

Passive Income Dude


  1. No inflation is bad, some inflation is best, but high inflation is terrible. Go ask people in Zimbabwe, Argentina, or Venezuela what runaway inflation does...

    Thanks for a thought-provoking article!

    1. Yea, I agree. I can't imagine experiencing inflation levels similar to one of those countries! However, I'd also safely say that the chances of that happening here are probably extremely low. Our central bank and government are much more equipped and structured to prevent a similar scenario, our economy is much more diverse, etc.. Thanks Ferdi!

  2. Higher interest rates are good for your existing debt locked into a fixed rate, but if you are looking forward to more borrowing, such as for another property, higher rates will hurt you. Also, higher interest rates could potentially lower stock returns because fixed income securities will become more attractive, especially to risk-averse investors and retirees. Right now, many investors buy dividend stocks because they can't get a decent return from bonds. Once interest rates go up, these investors will sell off their stocks and buy bonds.