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The Market Knows Best: The Federal Reserve and Interest Rates – An Update!

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At about the same time last year we saw the Federal Reserve raise the Federal Funds Rate by 0.25%. In anticipation to the Fed’s announcement, investors took to the markets to try and get ahead in terms of positioning themselves for the change. We wrote an article covering the overall market’s reaction in and around the time of the Fed’s announcement and what we concluded was that the market moved well in advance of the Fed’s announcement of the rate increase so investors who waited for the announcement already missed out. One of the best analogies that come to mind is trying to drive your car by looking through the rear view mirror.

Many investors may feel compelled to change their long term asset allocation in attempts to profit from these interest rate announcements. One would expect that long term bond investors would get hit the hardest, but even investors who stick with short to intermediate term maturities may want to shorten up even further; even just hang out in cash for a while. The main problem with taking this approach is that the investor is assuming that interest rates are certain to go up in the future, which is actually untrue. Interest rates will continue to go up and down based on new information and in somewhat independence of the Fed’s decisions – although their decision is a piece of information being taken into account. For example, although the Fed announced on December 16, 2015 that it was raising the federal funds target rate, interest rates subsequently fell for the six months following that announcement, leaving many investors who shortened up their bond positions on the sidelines. The conclusion to this story is that the Fed doesn’t have complete control over interest rate movements and since nobody can predict their future movement with a high degree of certainty, it is best to just stick with your long term asset allocation and not make major changes based on most recent events.

Similarly, this year the Federal Reserve has decided to raise its federal funds target rate from its range of 0.25%-0.50% to 0.50%-0.75%[1]. We would expect that the market has already anticipated this announcement and adjusted bond prices accordingly.  In fact, we can see that interest across US Treasuries of varying maturities started increasing by as early as September of this year. See Exhibit 1 below.

Should investors flee their fixed income securities given the recent rise in interest rates? Of course not! Similar to what happened just a year before, interest rates are going to fluctuate regardless of what the Fed decides to do. IFA advises our clients to invest in short term, high quality fixed income in order to dampen the risk of stocks in their globally diversified portfolio. We do not subscribe to the strategy of adjusting our exposure based on anticipated changes in the yield curve. It would be analogous to trying to time the market, which can be summarized as being a fool’s errand.

 


[1] Longo, Doug. The Fed, Yields, and Expected Returns. Dimensional Fund Advisors, LP. December 15, 2016.


About the Authors

Tom Allen

Tom Allen

Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.

Mark Hebner

Mark Hebner - Founder, Index Fund Advisors, Inc.  

Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.