Tahoe-Truckee Market Beat: Breaking down the Fed’s zero interest rate policy
September 19, 2016
Interest rates have been at an all-time record low, due to the Fed's ZIRP — zero interest rate policy — designed to stimulate the economy.
The current fed funds rate is 50 basis points, or one half percent. The Fed will conclude its two day meeting Wednesday with an announcement on interest rate policy. We'll see if they decide to raise the rate at this meeting or kick the can down the road to the next FOMC meeting.
Even if they do raise rates Wednesday, rates are likely to stay low for some time. The Fed looks at a variety of data when voting on their interest rate decisions. They consider inflation, GDP, the strength of the labor market and other economic data.
The Fed would like to see some inflation and has a target of about 2% for the CPI, consumer price index. A part of their mandate is to provide for full employment, so they consider the unemployment rate and other labor market statistics. The labor market has been fairly healthy recently.
Whether they raise rates or not, investors should understand how a rising rate environment can affect their portfolio. The last few years have been a very difficult time for conservative investors and savers who want income, but do not want to take on much risk. Low risk investments like bank savings, certificates of deposit and Treasury bills offer no return.
Many investors have been "reaching for yield" or "stretching for yield" by buying long dated bonds, dividend paying stocks and high yield bonds with poor credit ratings.
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Bonds will drop in value as interest rates rise. The amount a bond will decline can be determined by using a complex mathematical formula known as the duration. The duration of a bond will let you know how much the bond will fall in market value with a 1% rise in interest rates.
It could be possible to lose money in real terms with long dated bonds in a rising rate environment even if the bonds don't default. For example, if you purchased a thirty year US Treasury bond today, the yield would be just over 2.4%.
If rates rose and you wanted to sell your bond at the market price, you'd have to take a loss. If you held it until maturity and the rate of inflation were to exceed 2.4%, you'd lose money in real or inflation adjusted returns.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.